Is the party coming to an abrupt end? Hardly. The equity market staged a minor correction which just means the really, really easy money is now a little harder to make. Why do I say this? The actual fall in number terms is the largest fall since 2008. However, in percentage terms the fall is only 2.5%. A fall was largely anticipated and needed given we have had few corrections over the last year. To put it into perspective this last week saw two falls in excess in 1% last year for the whole year we had only 10 days where there was a correction of 1%. This fall is a little noise and for retail that has ploughed earnings into the share-market a little wake up call. Volatility has risen but not to any significant levels yet.
The action that investors should be looking to is the direction that the fixed rate bond market is taking. Its course is a little different. Bonds had a tantrum and for good reason. How the bond market behaves in the future will be dependent on the events of the next few weeks. U.S. jobs data was strong. We saw about 200k of jobs added to the labour market. However, the trend is slowing not growing. Productivity is stagnant, and wages rose 9c for the month.
Wow, that’s going to add to inflationary pressures and that wage rise is what started the ball rolling. Was it this that set the market off? Maybe, the only problem is, wage growth has little to do with the economy or Trump’s tax cuts. It has all to do with mandated wage increases in 18 states. A number of states during the period mandated minimum wage increases. Some of these wage increases were being linked falsely to tax cuts and for many the wage increases were bitter sweet. A number of workers were let go over the period to allow the mandated increases. So, the wage increases were largely technical and not really reflecting a tightening wages market leading to inflation.
A number of pundits are leaning towards inflation as the catalyst and if so this makes the market somewhat easy to read. What really got the market going, in my view, is a very different scenario and it all has to do with debt. This week we will see the Treasury issue 1 -month paper. Watch the result because it will tell you how traders are viewing the period when Treasury is expected to run out of money. Treasury is expected to exhaust its borrowing authority early March.
The GOP have put themselves in a hole and the Democrats can easily manage an impasse to garner concessions. The current funding expires Feb 8 and a stop gap is in place until March. How the Treasury funds itself over the period will be interesting as last week saw the weakest demand for a long time for 30-day bills and this trend is likely to continue. March bills are trading higher than other longer dated bills. Meanwhile, we also have larger than expected auctions for shorter maturity bonds. There is a lot of funding to be done.
Bonds, whilst fixated on inflation, also are concerned about whether the growth of the U.S economy will be sufficient to get to 3% and get somewhere close to revenue neutral. The GOP assertion may well turn out to be a pipedream. Globally, central bankers have the dilemma of global growth and what to do. That is exactly the problem Carney of the BoE is currently facing. Raise rates and risk slowing the economy.
For the Fed there is growth, the economy is now very mature, and the deficit is ballooning. Additionally, QE is slated to slow the purchases and reinvestments of coupons will stop. Corporates that are taking investments from other jurisdictions such as Apple will be selling bonds and central banks won’t be investing $100 bio a month. All of a sudden, rates look like they are starting to normalise. Rates will be rising for a while, volatility will increase and eventually this will start to hurt equity valuations. But for the moment, the tantrum that we saw in the equity market is a storm in a teacup.
What will be really interesting to observe will be how the Algo traders fare during this period. With low volatility it’s a no brainer. Buy anything you are a winner. And for many algo traders this period has not been so fruitful. This analogy goes hand in glove with index funds as well. In periods of low volatility, they of course will do well but what happens when the market is choppy the returns will slump just like the indices and the real art of valuations and market understanding will bubble up to the surface. For too long it has been simple to make money. Place a bet and you win. That time perhaps is coming to an end.
Investors should also take note of the simmering tensions between the U.S. and China over trade. China looks set to retaliate following the U.S. decision to impose tariffs on some Chinese goods such as solar panels and steel. China is set to place a tariff on sorghum and other U.S. agricultural goods. This will hurt farmers and place pressure on Trump. Whatever happens the scenario for U.S. growth of greater than 3% looks difficult especially with a slowdown in the agricultural sector. For example, the State of California’s main contributor to its GDP is agriculture.
Watch Bonds for the moment because if they become sceptical about a possible ballooning deficit then bond rates are set to move a lot higher. For the Fed it wants to hike rates three times over the year, the bond market may well do that for them and then you will have the Fed behind the curve trying to keep up with rising bond rates. The unravelling is not here yet but the risks are now rising as the party is slowing.
Bitcoin hit below $9,000 and traded towards 8,000. A number of regulators are starting to now take interest and it is now harder to purchase bitcoin on your Visa card.
Equities: The S&P 500 fell 2.1%. The Dow fell 2.54%. The Stoxx 600 fell 1.4% and was down 3.1% for the week.
Currencies: The pound fell 1%, the euro rose 0.4%, the Bloomberg Dollar Spot Index was up 0.8%.
Bonds: The ten-year hit 2.84%. The 2-year closed at 2.14%.the ten-year bund closed at 0.70% and the UK gilt closed at 1.57% and the OAT closed at 1.015%. The U.S. curve closed 2/10 at 69.6bp, 2/30 at 94.2 bp and the 10/30, closed at 24.4 bp. The U.S. 5-year closed at 2.59. The curve steepened between 2-years and the longer dated maturities, whilst the 10/30’s remained flat. Expect some volatility in the curve and quite possibly expect some flattening again.
Commodities: Gold fell 0.8% and WTI fell 0.5 %. Blockchain will be used to track Congo’s cobalt from mine to buyer. Lead hit a 6-1/2 year peak closing up 0.6%.
Aussie Market Today.
Expect some carnage in our markets today. The stronger U.S. dollar had an impact on commodity prices Friday causing some commodities to come off their highs. This should lead to a softer AUD. The equity market will follow the trend and sell.
Bonds will be caught in a tough spot. With equities being sold the first instinct will be to buy. However, with rates peeling off elsewhere the initial movement may well be weaker, followed by some profit taking by the shorts and then we could see some buying opportunities.
The movement in the U.S. bond market took most by surprise and this negative tone probably will hold over for the next few days especially as we come to the debt ceiling in the U.S. on February 8. The trend is likely to be weak.