The Unwind Of QE Means The “S&P Should Be Trading At Half Of Its Value”, Deutsche Bank Warns

In his latest weekly note, DB’s derivatives analyst Alekandar Kocic focuses on the interplay between US inflation expectations and US equities, and points out something curious, and very much spot on: 

Policy response to the crisis post-2008 consisted of unprecedented injection of liquidity, transfer of risk from private to public balance sheet, and reduction of volatility from its toxic levels. The net result was near-zero rate levels and collapse of volatility across the board, while different market sectors developed high degrees of coordination. The last effect has been an indirect result of the central banks’ flows and the distortions they introduced in the bond market. In this environment other markets acted as a complement to rates (through which monetary policy was transmitted) and crowding out there pushed investors to articulate their views elsewhere. Their participation was a function of amount of liquidity injection. As a consequence everything was trading off of US inflation expectations as the main expression of the QE effects.

That was the case for the first 5 years of “unconventional policy” until some time in 2013. Then something snapped. Kocic continues: 

With deflation as the main risk tackled by monetary policy, its success or failure was gauged by the ability to reflate the economy. Inflation expectations and breakevens were therefore signals for risk-on or risk-off trade. In fact, most market sectors, from FX to EM equities, were trading in high coordination with breakevens. Taper tantrum was the end of these correlations and a beginning of dispersion across different assets. In effect, it was the unwind of the “QE” trade, its first phase. While most other assets, like credit spreads, EM equities or different currencies, do not have a logical connection with US breakevens, US equities do. The dispersion between these assets and breakevens was an expected consequence of policy unwind. However, for US equities this unwind distorted their “natural” correlation with inflation. Persistence of these dislocations is just a manifestation of to what extent QE has been an important driver of post-2008 markets.

Which brings us to the punchline: 

Since 2013, stocks rallied while disinflationary pressures were reinforced by a strong USD, low commodity prices and a decline in global demand. If pre-2013 coordination between the two is taken as a reference, then based on current stock prices breakevens should trade about 1.5% wider. This means the Fed should be hiking because inflation is above target. Alternatively, given the current level of inflation, S&P should be trading at half of its value.

Wait, the S&P should be trading at 900… or even less? Yes, according to the following Deutsche Bank chart:

Only one question remains: which breaks first – do inflation expectations surge higher, soaring by some 150 bps to justify equity valuations, or do equities crash?

 Is reconciliation likely – and, if so, in which direction? Are we returning to the pre-crisis world, or we are in a completely new regime?

The answer will come from none other than the Fed and by now, even Janet Yellen knows that one word out of place, one signal to the market that the QE-inflation trade will converge with stocks crashing instead of inflation rising (which, unless the Fed launched QE4, NIRP of even helicopter money now appears inevitable), and some $10 trillion in market cap could evaporate overnight.

Is it any wonder that Yellen is exhibiting “health issues” during her speeches: the realization that the fate of the biggest stock market bubble lies on your shoulders would make anyone “dehydrated.”

In retrospect, Ben Bernanke knew exactly what he was doing when he got out of Dodge just as the endgame was set to begin.