Snap! As many have said, something had to give

Friday, 12th October 2018 14:07 - by Shant

This has led to the Fed stepping up its rate normalisation program and after 3 hikes of 25bps this year, we are still looking for a fourth in Dec despite the softer CPI print on Thursday this week.  Naturally, this lifted real rates in mathematical terms and hence took its toll on leveraged risk.  Add in the level of exposure in ETFs, and the exponential dynamics of a sell off are magnified, so the question is, is there more to come?  Well, this all depends on the Fed and whether they truly will look past the events of this week.  After all, corrections are all part and parcel of free markets, right?  Yes, though this did not stop the president from taking to social media and aiming some pretty blatant criticism towards Fed and their 'crazy' behavior.  Setting up the Fed for the fall? Very likely.  The president has been doing his all to make America great again and anyone not conforming to his view comes under fire  We know this.  But what is the Fed to do?

Based on their mandate, employment and inflation, they have no choice but to act accordingly and tighten policy.  Subtle comments from the Fed chair that he hopes the government will exercise fiscal responsibility went under the radar, but this was a veiled warning that in good times, they need to pay down debt. Are they?  It doesn't seem like it.  Tax cuts, infrastructure spending - Trump is still insisting on the wall with Mexico - all suggest that moderation and debt reduction are not in the plans.  The longer the US persist with boosting the economy, both from a fiscal and monetary standpoint, the longer they believe economic strength can mirror the trajectory we have seen on Wall Street stocks.  A form of catch-up if you will. 

Earlier in the week, I noted the Fed's need to watch out for inflation and a possible overshoot.  As such, I would argue that the latest reading was a blessing, with real earnings picking up as a result, but under the current administration's program, CPI should go higher.  The combination of higher inflation and higher interest rates is a dangerous cocktail in the current environment and one which does not bode well when wage inflation is tepid to moderate in such optimistic times.  Once again, there is little purpose in comparing the real economy to what is reflected in the stock markets in the aftermath of what has been unprecedented monetary stimulus, yet there is a point at which it will and does matter.  The latest developments this week suggest we are getting close if not here already.  

So the question is now whether the stock market sell-off has put a cap on the yield curve - and investors start buying bonds - or whether investors consider higher rates justified and reflective of economic strength, in which case bonds continue to sell off and the benchmark 10yr Note pushes up to 3.50%.  If it does, all eyes are then on the 30yr and how this reacts, though at that point holders equity investors are likely to have suffered more pain.  Correlation watching continues. 

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.