Turning Point?
Is it the time of exaggerations?
The trend continues, with financial markets starting not very good into the new year: With expectations of a tighter monetary policy by the Fed and, of course, a smoother (possible) tightening by the ECB, stock markets are not in the best mode these days.
Especially growth stocks suffer from the expected monetary policy steps, and investors start to turn their eyes to value again. Especially high yield dividend stocks, as Bloomberg notes:
The MSCI World High Dividend Yield Index has climbed to its highest since May against the global stocks benchmark and has smashed through the relative downtrend it had been in since pandemic fears peaked in 2020.
Regarding a continuation of rising yields in the short term, I expect this trend to continue…
What brings me to the main driver behind the recent stock market moves: The bond market. Since the December Fed Minutes were published (I wrote about this in ‘Crashing Around You’), expectations seem to get more and more extreme.
Since my last post, voices urged the Fed to act faster and tighten much sooner. For example, Bill Ackmann tweeted out that the Fed, to re-establish credibility, should raise interest rates by 50 basis points in March (although I never thought that the majority of market participants has ever lost trust in the Fed because otherwise, we would deal with a much different environment).
Fed governor Christopher Waller clarified: In his view, the market should expect three to five rate hikes this year, although he added that one has to observe how inflation is developing in the first half of the year. However, he denied plans to hike rates by 50bps in March.
Hence, stocks and bonds continued their correction this week, and US and German government bonds are now higher as before the pandemic hit.
The recent developments with the omicron variant might be a factor in it. As I wrote last week, the current variant is much less severe than the Alpha or the Delta variant.
While Austria is making the Covid vaccine compulsory for adults (Germany could follow), the Czech Republic reversed course and dismissed plans to make covid-vaccinations mandatory for over 60-year-olds. Even the inventor of the Hammer and the Dance, Tomas Pueyo, has officially declared: Game Over (for the pandemic).
If we look at the stock prices of vaccine developers, the market seems to agree. In that sense, Gustav Mahler may be proven correct again, that things happen much later in Vienna than elsewhere.
However, let us get back to markets: Not only US 10y Treasury yields are close in reach of climbing to 2 % now, but German 10y Bunds also celebrated a comeback and turned positive for the first time since 2019.
The yield curve nicely shows the difference between the pace of monetary normalization in the US and Europe.
Since the American re-opening of the economy, the US 2s10s spread has narrowed by more than 50bps while the 2s10s Bund spread has widened. In contrast to the Fed, the ECB still is not ready to give up its’ loose monetary policy, despite recently admitting that inflation might be stickier than they thought.
However, the Fed seems trapped because the market expects it to normalize monetary policy quickly. It is not unlikely that it will make a policy mistake and raise rates too fast and strangles economic growth, or it acts too hesitant and possibly loses control over inflation.
In my opinion, this is the cause of the latest equity sell-off. Inflation expectations have changed dramatically to the upside, and the market is heavily pushing on the Fed to take action. Just take a look at the Eurodollar futures curve: The market is expecting yields back at 2 % in the second quarter of 2023 already.
In the Eurozone, the curve has steepened to, but on a much more minor scale. While the market expected that interest rates in the Euro Area would be back at zero in 2024 one month ago, the market now expects zero percent interest rates in Q1 2023.
However, I am unsure if markets are not too optimistic, especially about US rates. My hunch would be that the Fed cannot raise rates that easily without risking to prick the asset bubble they have created. Contra wise to my opinion, Jamie Dimon even thinks that the Fed will hike rates six or seven times this year.
Well, I beg to differ and would argue that inflation would need to overshoot expectations big if Jamie Dimons’ case should become a reality.
Despite many analysts who declared that inflation was transitory last year are now jumping on the inflation bandwagon and saying that inflation will remain at high levels, oil prices seem to underline the story of slowing inflation.
I suspect that inflation will be lower than expected soon and could catch some investors by surprise. Maybe not in the first quarter, but definitely in the second quarter when base effects hit in, and we will get what I expect to be lower than expected GDP numbers.
And I think that the Russel 2000 is already showing some weakness of the US economy. As in Germany, the main driving force of the American economy is small and medium enterprises. Hence, the backbone of the US economy is already signaling a top since Q3 of 2021.
The rise in yields does not make the situation any better, given the enormous debt levels of businesses. Which brings me back to the question of whether the Fed is even able to hike rates very much without causing economic turmoil?
Hiking rates right into a slowdown has never been a wise idea. At the latest, monetary tightening may lead the US economy into recession in 2024.
While everyone pointed to catch-up effects last year because of a high savings cushion, the situation is much different today. Although the reflation trade was much more of a thing in the US than in Europe (namely, because there was always a little restriction somewhere), savings are down and nearly back at pre-pandemic levels.
The loosening of the PBoC may stimulate the world economy a little bit, but I do not expect it to last very long, given it was just a 10bps rate cut of the 1y loan prime rate. I guess that the Bank of China wanted to assure everyone that it would react just in case (and I am still not very sure about that even, given the weak banking sector in China)
The situation will remain challenging in both the stock market and the bond market. Thus, we might see the US 10y Treasury yield above 2 % and 10y Bunds in a range of 0 - 0.25 %, probably a buying opportunity for duration.
The Fed will continue its tightening process (it simply has to satisfy market expectations). The ECB will remain hesitant (or patient). Hence, I would expect the dollar to appreciate further against the Euro.
Further, the Federal Reserves’ tightening process will also lead to a contraction of the supply of Eurodollars, which would be an argument for a more valuable dollar. Probably not a good sign for emerging markets…
However, sooner or later, the economic slowdown and rising rates on the short end may force the Fed to reverse course again and to start an easing cycle once again. In my opinion, the only question is when…
Have a great weekend!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity.)