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- The violent rotation in equities is sparking hopes of a fundamentally-driven rally
- It has been aided by record fund inflows and a spike in CB liquidity
- But the details of both the flows and the liquidity leave us skeptical
- Expect the rotation to continue, but not the rally

- Recent statements are a reminder of the importance of neutral rates for policymakers
- But they also illustrate confusion – not only about the level of r*, but even as to what it is supposed to be measuring
- At the heart of the confusion lies a failure to distinguish between the impact of balance sheet on markets, and of rates on the economy
- This potentially leads to very different conclusions for r* and policy

- Markets and economies should be analyzed as ‘complex systems’
- Their fat tails and emergent behaviours fit poorly with traditional linear economics, but very well with complexity modelling techniques
- Lessons from other complex arenas apply equally well to investing

- We have been arguing markets face greater risk of melt-up than melt-down
- But the speed and extent to which many levels are deviating, not only from fundamentals but even from many technicals, is striking
- Expect fund inflows to continue to swamp such concerns – but watch for any sign of faltering

- The significance of last week’s FOMC lies neither with the rate view, nor with the earlier, larger taper of QT – mildly bullish though both of these are.
- It comes instead from the stark asymmetry of the response function which was described.
- While the true test remains with the details of the liquidity outlook, in conjunction with the Treasury refunding this opens the door to a continued cross-asset rally through Q2.

- Relative CCC cliff risk has risen to record highs
- This partly reflects hidden idiosyncratic risks from low recoveries and abandoned covenants
- But mostly it signifies the macro suppression of index spreads

- The $280bn weekly drop in Fed reserves is the largest since Apr22
- Just as then, it coincides with a correction in markets
- A drop in fund inflows seems likely to follow
- But this still feels more like seasonal correction than decisive turn

- The latest central bank research on QT is careful, rigorous, and grounded in the literature
- Unfortunately its main conclusion – that QE affects markets while QT doesn’t – is at odds with the lived experience of most market participants
- There is a much simpler reason why QT has had so little apparent impact
- Misunderstanding of this dynamic greatly contributes to the likelihood of future policy mistakes

- The rally in risk is often attributed to strong earnings
- But calendar earnings estimates have mostly been falling
- Macro drivers, not organic estimate optimism, are the true source of the markets’ strength

- After several months of liquidity tailwinds, risk asset pricing is starting to look excessive
- Improving spending, orders and hiring are all positives
- Despite this, earnings estimates are falling
- Fundamentals are reflective more of sticky supply than of dynamic demand
- Ongoing price pressures may well curtail central banks’ desire for dovishness
- But excitement about higher r* remains overdone