Dudley to market: remain calm, all is well

Where to begin?  How about with Bill Dudley, who gave a speech yesterday essentially saying "nothing to see here, please disperse" when it comes to bond market liquidity (or lack thereof.)  To say that the argument was uncompelling and smacked of complacency is an understatement; for example, Dudley's analysis focused on dealer-to-dealer transactions in the Treasury market while ignoring client-to-dealer transactions.  Moreover, by focusing on measures (such as deviation from fitted yield curve) that he himself admits were distorted by the Fed's zillion dollars worth of asset purchases, Dudley essentially rendered his argument tautological.

Unsurprisingly, other analysis comes to a different conclusion such as the chart displayed in this article showing how daily yield moves in excess of 1 standard deviation are at historic highs since the implementation of Dodd-Frank.

Dudley wrapped up his argument with the usual "even if liquidity has declined, it's a small price to pay for financial stability."  That's easy to say, but there is of course no guarantee that the deterioration of liquidity has conferred (or coincided) with overall financial stability...and that's without pointing out the logical fallacy that maintaining ample market liquidity and financial stability are somehow mutually exclusive.

As for those who've been bulldozed in the least liquid segment of the corporate sector, where price becomes news, here's a succinct summation of Dudley's message to you:




Moving along, focus today is on the ISM, where despite the published consensus forecast of 50.7 the whisper number is below 50.  Yesterday's execrable Chicago PMI number has surely fed the tide of negativity.  Given the weakness in other regional surveys, the market's pessimism would appear justified, though the historical correlation between the regional reports and the national figure are relatively modest.

While it would appear unlikely that the Fed would move policy with the ISM below 50, no one actually expects a move in October anyways, given the S&P 500's audacious failure to rally.  Putting things into context, however, it's important to recall that manufacturing is a relatively small (if visible) portion of the US economy.   A composite measure of the manufacturing and services ISMs, weighted 30/70 to reflect their relative importance, suggest things are nowhere near as bad as the usual prophets of doom might suggest.

Obviously, things can change....but right now Macro Man isn't seeing the sort of deterioration that would serve as a legitimate cause for alarm.

Speaking of which, there have been some fairly bearish viewpoints espoused in the comments section recently, and Macro Man was amused to see Carl Icahn star in a video expressing a similar sentiment.  Your author was shocked, SHOCKED to see Mr. Icahn, who owns many billion dollars worth of corporate equity, recommend steep corporate tax cuts as a solution to the current malaise.

The fact is, however, that corporate profits are generally doing just fine, thanks to a whole host of advantages that companies enjoy which Joe Sixpack does not.  Macro Man has touched on this before, but profits (and market expectation of future profit streams) do an excellent job of defining the secular cycle in US equities.  The current state of play, quite simply, does not suggest an imminent collapse, nor that this is 'the Big One'.  If anything, the time to make that argument was 6-9 months ago, which was exactly the point when Macro Man was fuming about the lack of volatility in the market.

History suggests that when earnings expectations are pointing up and the market's pointing down, it's the market, not expectations, that tends to correct.  Perhaps this time really will be different.  Macro Man cannot shake the view, however, that while we have moved into a higher volatility regime for the foreseeable future (thereby reducing the ex ante Sharpe ratio of holding risky assets), the ultimate resolution will be higher, demonstrating this to have been a correction rather than the start of a new bear market.