A chicken and egg situation

Wednesday, 17th October 2018 08:13 - by Shant

Last week's sell-off in the stock markets was not one we could brush off as we seem to routinely do these days.  After a megacycle which has seen a parabolic bull run since 2009 send the leading S&P 500 from the mid 600's to within 60pts of the 3000 mark, we finally got a taste - or as I see it, a confirmation - of what levels if interest rates constitute a point at which you cannot turn your nose up at risk free money.

Treasuries are after all the safest game in town - assuming the current US administration temper their spending habits.  It should not have gone unnoticed that the US deficit has grown by 30% over the past year, yet the president is keen to embark on a second round of tax cuts.  With employment as low as it is and job prospects as positive as they can be - job openings at record highs (over 7 million) - quite why this is a priority over paying down government debt is beyond me.  

Nevertheless, markets will focus on the here and now, and the US is by far the strongest economy in the developed world and the investment community seems happy to worry about the eventual correction when the day comes.  Well, given that we saw 30yr Treasuries stalling ahead of 3.50%, we seem to have our marker for terminal rates in the US, with the benchmark 10yr Note finding buyers at 3.25% or so.  With inflation ticking lower over the near term, it seemed an opportunity too good to miss at those levels and the resultant flow out of equities saw a 3-4% drop on Wall Street.  As we spoke of last week, the Fed has little choice but to follow their mandate.  On current metrics, unemployment is at long-term lows, and with inflation comfortably above 2.0%, rate hikes are coming no matter how much this displeases the US president.  Some fund managers believe that the yield curve has higher to go and that we could see the 30yr reaching 4.0%, but at this stage, based on the reaction we saw last week, will the Fed precipitate such a move which could really see stocks over the edge?

At this stage it is a tough call, since the financial crisis, stock markets have been given every opportunity to thrive, and barring any material turnaround in the US data, the Fed seems destined to fulfill the dot plot which sees the end rate topping out at 3.50%.  In their rush to price this in as quickly as possible, bond markets have jumped in aggressively, meeting top end expectations with breakneck speed.  While markets are always ahead of the game, modern day dynamics show that there seems to be scant regard for valuation based on time, and/or the relevant impact on the rest of the asset classes.  This has led to series of breakdowns in the traditional correlations, though thankfully, it was good to see Gold fighting off the 'paper selling', which was a clear example of how excessive leverage can distort the markets.  Not suffice with expressing their view on rates through the Treasury curve, selling 'funding costs' for precious metals was another avenue being exploited.  Real money eventually won out here, with the shiny stuff back well over $1200 again.  

Back to the fundamental backdrop, and we find ourselves asking whether Treasury yields will continue higher, or whether they will be constrained by their impact on equities.  Despite having been in and around the market since the mid-1990's, never has there been a time when stock markets have felt so resilient to almost any risk event or corresponding market dynamic which would have unsettled the apple-cart in days of old (ish).  We are constantly reminded of the fact that after a period of unprecedented cheap money, the longevity of the bull run was always going to be impacted - all well and good in hindsight.  This now seems to have given the market an air of invincibility that can only be described as worrisome, to put it modestly, though with QE programs still in play elsewhere in the world - see Japan - 'investment flow' has not 'run out' just yet.  The ECB is also running their program until the end of the year, though their influence on global stocks is less of notable.   Even so, cheap money is still out there.  

Perhaps the confluence of policy tightening around the world is what will eventually call time on the party of all parties.  When you listen the BoJ rhetoric, it seems this is unlikely to happen any time soon, but what we do know is that US Treasuries and stocks seem to have hit a combined 'sweet spot', though not so sweet when you consider which way the balance of drivers are 'pushed'.  

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.