For the Donald, today was not a good day. President Trump likes to think that the market ups are all his doing and the reason why is all because of him. Today was a black-eye. The equity market was bloodied and bruised and for good reason. Yes folks, believe it or not, interest rates are moving higher and the risk-off trades which acted before as a pressure valve are just not eventuating.
Valuations into next year appear stretched and the equity market is readjusting. Correlations are breaking down and the Vix is climbing rapidly. The correlation between the iShares20 + Year Treasury Bond ETF is the most positive on record. The last time it was positive was in 2006. So where were Kudlow and Trump today?
The U.S. stock plunge was the most since February (Bloomberg). The S&P 500 was down 3.3% and the Dow was down 3%. The FAANGS were belted but so to Boeing and Caterpillar which were both down 3.8%. For the luxury brands, today was not good. It would appear as though China is enforcing its tariffs on the likes of Tiffany’s, LVMH, Estee Lauder and the like. China is starting to appear as having an impact.
The bond selloff may appear anaemic but the movements in percentage terms are huge and with those changes borrowing costs escalates. And when you are as leveraged as some companies and have to then roll in the new environment, borrowing to pay increased dividends suddenly does not look like a smart decision. Taking the tax cuts and not reducing borrowing but paying out dividends or doing buybacks does not look smart. Only just now the penny is perhaps dropping. And if tomorrow’s inflation data is firm, then traders will fret and the current momentum will only be exacerbated.
Bonds and equities are doing what they should not be doing – they are moving in unison. The normal inverse correlation is the weakest in two decades and there is some cause for concern. Each time the correlation changes the equity market slumps. And perhaps we are just starting to see the beginning of that slump. For twenty years, stocks and bond yields have been positive and each time they flip, a significant equity market correction has occurred.
A rupture in positive correlations, that is, yields in lock step with equities and both weakening would suggest that the economy may be in for a period of weak growth. In this environment, the circuit breaker then becomes the Fed easing. The Fed this time cannot ease without buying lots of bonds because the Treasury has to issue lots of bonds to pay for the ballooning deficit. And the white knights from offshore, well, they may not be around to save the maiden because the basis for European or Japanese investors makes an investment not worthwhile. The costs of hedging are too high and once swapped back, the returns are actually higher in their own countries. So who will buy my beautiful bonds?
The current rout in Treasuries is being caused by a changing sentiment and an uptick in yields. Fear of inflation has not come to the fore just yet. The steepening of the curve has some seeking solace. But in the authors view this is exactly what has to happen before we see the curve invert. Liquidity is drying up, issuance has increased and buyers demand a higher yield to invest. This eventually dampens the economy and the yield curve flattens.
The great conundrum is where too from here? Should investors be preparing for more hawkish actions from central banks or is it steady as she goes? Parallels may be drawn with 1987 where the ECB, like the Bundesbank in 1987, could withdraw more liquidity than expected. The great risk is that both the ECB and the BOJ prove to be more hawkish than expected.
One only has to realise that since 2013, U.S. bond yields were suppressed as a result of easy money sloshing around the system courtesy of accommodative policy from both the ECB and BOJ. This risk is elevated as Klaas Knot (ECB Governing Council) suggested: “policymakers should speed up the process of removing their extraordinary stimulus if the euro-area economy meets their projections”.
For those of us looking forward to a bear market, one should consider this one pertinent fact. Bond market bear markets cannot persist if there is no or little movement in inflation. Markets can become tired and unwilling. However, we will need to see a spike in inflation if the bear market is to be confirmed. Despite the recent rises in bonds, the breakeven rate on treasuries is back to where it was several months ago. Perhaps the catalyst will be prolonged significant issuance with a modest increase in inflation. For the moment though, we need more information to change expectations.
However, issuance of treasuries will play its part in any bond bear market and it won’t matter who is in power. If the Democrats win the midterms, they will propose an infrastructure -spending bill. And if the GOP wins then tax cut 2.0 is highly probable. Either way, the U.S. taxpayer will be burdened with a larger pile of debt.
The deluge of supply is set to grow beyond $15.3 tr at a time when borrowing costs are rising. The U.S. budget deficit is expected to swell past $1 tr in 2019 and steadily increase in subsequent years. The interest owed is forecast to triple over the coming decade to $ 1tr per annum according to the Congressional Budget Office. That should sober up any bond bull.
At some point, irrespective of inflationary expectations, the bond market is going to say sayonara big fella and let someone else buy the bonds. And that means bond yields accelerate upwards in yield. Maybe the canary in the bond market has already started to chirp. The last bond auction for the 10-year treasury saw demand fall to a decade low and that was when the 10-year at its highest point since 2011. Enthusiasm for bonds is starting to wane.
The lesson to be learned here is that in an environment where you have ballooning debt, ballooning interest payments, ballooning issuance and liquidity being better allocated and also reducing, it is inevitable that both rates and bonds rise in yield. The U.S. is easing fiscal policy at the wrong point in the cycle and the problems of today will manifest themselves profoundly in the future.
The Rating Agencies should also start to worry about the ballooning debt and interest payments.
As a sobering thought, the debt burden for the U.S. is set to increase by $10 tr over the next decade. If the GOP wins, they will attempt to make its tax cuts permanent. This will only exacerbate the debt problem. And one wonders whatever happened to those stoic vitriolic hawks that now are content to trash any chance of fiscal responsibility? Kudlow, Dimon and a host of investment bankers and elected members, whatever happened to those concerns when they are so blithely and happily raising the future debt burden?
Equities: The S&P fell 3.3%. The Dow fell 3.2%. The Nasdaq lost 4.4%.The Stoxx fell 1.6% The Vix closed 21.19, a significant increase in volatility.
Currencies: The Bloomberg Dollar Index fell was steady. The yen climbed 0.4%. The euro rose 0.3%.
Bonds: The ten-year closed around at 3.193%. The 2-year closed at 2.856% and the 30-year closed at 3.375%. The ten-year bund closed at 0.552% and the OAT closed at 0.9010%. The U.S. curve closed on the day with the following closes 2/10 at 33.5 bp, 2/30 at 51.3 bp and the 10/30 closed at 17.90 bp. The U.S. 5-year closed at 3.025%. The curve flattened steepened between 2 and 3 bp today.
Commodities: WTI fell 2.8%.Gold gained 0.4%.
Bitcoin is trading around $6,538.
Aussie Market Today.
The ASX is likely to remain nervous. The Asian selloff will only heighten fears. Bonds appear to be on a negative trajectory and that will hurt equities for the moment. In fact, today looks like a sell in the morning and forget. I expect the ASX to be sold on the day as Asia will no doubt be aggressive sellers in their home markets and that will only reinforce the sentiment. Sell!
Bonds could be tricky on the day. You may see a rally in response to the equity market selling and don’t be fooled. The Australian economy should get weaker as the drought kicks in and weaker commodity price with lower volumes will eventually hit home. The RBA is caught in that it really cannot now look to hike rates as the economic outlook is relatively weak. The issue will be the trade deficit and investor appetite. For the moment, being in negative territory with U.S. bonds, the bond market should be weaker. But it is not. If selling does occur it may be short and nasty. However, that could be an indicator to do a little buying. Be wary.
On an interest differential basis and weak commodity prices, there does not look like much respite for the Aussie short of intervention by the RBA. I expect the weakness in the Aussie to continue.
Geopolitical risks remain high.