Morgan Stanley’s Neil McLeish and Jason Draho write that the Fed’s tapering talk has triggered a “mid-cycle correction” that’s in an advanced stage, but probably not over.
What’s a mid-cycle correction?
Mid-cycle corrections are typically driven by one of two things, either a normalization of monetary policy or a large systemic event. This one falls into the former camp. While we realise that the Fed is not tightening policy, but merely easing less aggressively, this effectively amounts to a normalization of monetary policy that in past cycles would have been equivalent to actually raising the policy rate.
Unfortunately, this normalization is arriving earlier than investors expected and certainly earlier than implied by their positioning in May,
This correction has been an unusual one, they write: usually bonds outperform.
The ‘normal’ rise in risk aversion associated with mid-cycle policy normalization was exacerbated in this cycle by the combination of huge secular growth in global fixed income markets over the last decade and the post-crisis shrinkage in dealer balance sheets. This is why credit-related product underperformed both equity and government bond markets in the current sell-off, the opposite of the normal mid-cycle correction playbook.
So how far along are we? Among the previous-eight S&P corrections, only two lasted more than 100 days. We’re barely at 30:
it is possible that the correction is already finished, but our base case is to expect additional volatility as we move into the third quarter.
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