Central Banks Won't Save Us From ‘Critical Stress’ in Stocks

Dudley Says Stock Selloff Is 'Small Potatoes'

Central bankers’ quest to wean markets off of stimulus raises the risk that the tantrum in risk assets will persist.

Bank of America Merrill Lynch’s “Critical Stress Signal” was triggered on Feb. 8 amid the simultaneous surge in volatility and selloff in stocks. Typically, that marks the moment to get back into risk assets. But this time looks different, say a team led by equity-linked analyst Abhinandan Deb.

“Beginning in 2013, with the taper tantrum, the Critical Stress Signal has been a remarkable contrarian indicator, as it has closely aligned with the timing of central banks either verbally or physically intervening to calm markets,” he writes. “But since the last stress signal in 2016, rates and inflation expectations have increased, we have a new Fed chair, and central bank rhetoric appears more hawkish, creating uncertainty over where the ‘central bank put’ strike sits today.”

Bank of America Merrill Lynch

Fed officials certainly haven’t sounded overly concerned about the retreat in risk assets. Outgoing New York Fed President William Dudley judged the drop in stocks to be “small potatoes.” St. Louis regional chief James Bullard called it “the most predicted selloff of all time.” And Dallas Fed President Robert Kaplan said market volatility may be “healthy.”

These testimonials suggest that the U.S. central bank isn’t seeking to short-circuit this stock slump by signaling that it could imperil their rate-hike plans or other dovish cooing. By contrast, the Janet Yellen-led Federal Reserve delayed rate hikes in 2015 after the surprise devaluation of the Chinese yuan sparked turmoil across global equities as well as other asset classes.

“For a Fed that has lamented elevated valuations in the equity market, the selloff in stocks is not especially concerning,” adds Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC. “It is way too soon to even be thinking about a Fed put. The strike price is far lower than where equity prices stand today.”

A Critical Stress Signal occurs when at least one quarter of the components that comprise the BofA’s Global Financial Stress Index rise swiftly in a 10-day period. In this instance, the majority of the alarms are emanating from the equity market.

“The risk is that the Fed reaction function has now changed, allowing for more stress before central banks step in,” Deb concluded.

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