Looking back on the best performance for the S&P in the month of June since 1938 reveals a familiar pattern: economy shows signs of slowing, earnings outlooks decline, equity market stumbles, Fed rushes in with the promise of easier policy, market rallies to new record (again)…problem solved. Completely predictable, and almost comical at this point. There aren’t many people left that think that the Fed’s real mandate of fostering maximum employment and price stability hasn’t taken a back seat to maintain the appearance that everything’s fine through higher stock prices.
How many times can they keep running the same play? Right now investors still seem willing to believe that the Fed can extend the business cycle forever, but it does beg the question of whether the economy and the markets are even viable without support from the central bank.
The big issue in front of us is whether another round of rate cuts can rescue the economy? It might. But the next big trade is going to be recognizing that tipping point if and when the markets and economy fail to respond.
Next month the current expansion will become the oldest on record. Investors need to start worrying about the marginal effectiveness of any potential rate cuts this late in the cycle, especially now that yields globally are already at rock bottom. Lower rates almost certainly aren’t the answer to a system choking on debt from the past decade of easy money, but apparently, that won’t keep policymakers from offering it up again. The minute the markets realize that the Fed and other central banks are shooting blanks the entire game changes.
Which is why housing data is worth paying attention to. Over the past week, a series of reports on pending, existing and new home sales showed a continuation of weaker year-over-year trends despite the stimulus normally associated with declining mortgage rates. It might be an early and important sign that aside from the raging bull market in equities, demand in the economy is slipping and becoming inelastic to the level of rates. See https://cnb.cx/2IHmcfT . So even if the Fed embarks on another round of rate cuts they may find themselves pushing on a string.
New Home Sales (blue) and 30 year mortgage rate (green and inverted). Chart courtesy Zerohedge.
Wall Street has coined a term for the opposing economic messages being sent by the bond and stock markets: Jaws. Look at a simple chart (below) with the S&P overlayed on the benchmark 10 year Treasury note and you’ll see what I mean.
It refers to the yawning gap that began to widen early this year as a function of sharply higher equity prices and collapsing bond yields. One side suggests a boom and the other signals recession. Describing it is the easy part, guessing how it turns out is not. Both can’t be right.
The image of “jaws” also infers a danger to investors from a trap created by conflicting narratives that will inevitably snap shut, in this case as the macroeconomic state of play becomes clearer. But from which direction will the jaws close and who is most at risk? Will the economy take off or hit a wall? Will bond yields rise or will stocks succumb? We don’t know yet. Presently, both markets trade well and with the confidence that they represent the winning side.
Jaws is a reaction to 1) slower growth and 2) the Fed’s anticipated response. There’s no doubt that the global economy has been knocked off it’s footing by disruptions in international trade. In the US, it also suffers from old age. Next month the current expansion, that began in June 2009, will officially become the longest on record. Bond yields have fallen sharply as the possibility of a recession appears on the horizon, accelerated by these and other headwinds created by sub-par economic activity worldwide.
On the other hand, equity markets have enjoyed an impressive recovery since the Fed called off plans for tighter monetary policy back in January. The S&P spiked to fresh record highs last week after Fed chairman Powell went a step further and all but promised to begin cutting rates again. See https://bloom.bg/2WLgykO .
As I see it, the risk inherent in the jaws trade is that the prosperity projected by the equity markets is becoming more illusory, when in reality the economy and the markets are only viable when the Fed is backstopping them. All-time highs in stocks seem strangely disconnected from the expectation that more than half of the sectors in the S&P 500 are set to report negative growth in this current quarter.
In the last 50 years, only a quarter of all recessions were averted by easier monetary policy. Investors feeling confident that Chairman Powell has their backs may be overestimating the capabilities of the Fed to sustain a business cycle that is already past its sell-by-date.
Five years ago this month the European Central Bank made the desperate move of imposing negative interest rates in an attempt to spur growth and generate price inflation. It didn’t work. Economic activity on the continent now is barely noticeable, the banks are teetering and market-based inflation expectations are the weakest on record.
European bond yields are literally collapsing in a panic after European Central Bank president Mario Draghi revealed his latest prescription for growth: do more of the same. Because current policy obviously isn’t extreme enough the ECB thinks even deeper negative rates will certainly do the trick. Genius. Yesterday the benchmark 10yr German bund traded at -0.32 bps and similar yields in Poland, Sweden and France hit zero for the first time in history. Negative yielding bonds worldwide, mostly in Europe, now total about $12 trillion. What’s the goal here? How are banks ever supposed to profitably lend money with such a distorted yield structure? It has long been suspected, but today’s events confirmed that Draghi and the ECB are officially out of ideas. Europe is toast.
A similar experiment in Japan also failed miserably. The widely touted “shock and awe” scheme by the Bank of Japan in January 2016 also included a move to negative rates, which in theory was supposed to boost the economy by discouraging saving and encouraging spending. It didn’t turn out that way and the country remains trapped in a decades-long deflationary decline. A recent Reuters report claims that BOJ insiders knew immediately that the move to negative rates was a mistake. Despite the fact that they have nothing to show for it after three and a half years, the policy is still in place. See https://reut.rs/2Il0Sww .
This should be a lesson to all investors as the Fed stands poised to begin another rate cutting program of its own, possibly as soon as next month. While it’s becoming apparent that what ails the economy is moving beyond the reach of traditional policy remedies, central bankers like Mr. Draghi and Mr. Kuroda (of the Bank of Japan) are still fighting the last war. We assume that the Fed would never follow their lead and take US rates negative but who knows? The Japanese and the Europeans probably never thought they’d end up in their current predicaments either.
The last Fed easing cycle started in 2006 with an overnight rate of 5.25% before falling to 0% by 2008. This time around, if rates are eased again, the starting point will be less than half that, at only 2.4%. If the Fed feels compelled to ease policy every time the equity market gets in trouble, we’ll be at that zero threshold soon enough. In fact, some astute Fed observers think that chairman Powell’s recent reference to the downside limit on policy as being defined by the “effective lower bound” rather than a “zero lower bound” cracks the door for rates below zero. We’ll see.
Predictably, stocks are loving the possibility of lower rates but are we somehow supposed to feel good about all of this? It ignores the reason why an easier policy is back on the table in the first place. How long can we play the “bad news is good news” game before bad news actually becomes bad news?
As I wrote last week in Aussie-Yen: Currency Canary Keels Over, either growth needs to accelerate or there has to be a reset lower in the financial markets. The contrasting messages coming from the bond and equity sectors are as stretched as at any time in recent memory (see chart below.) One side will ultimately win out, but the waning influence of the central banks definitely poses a risk for growth.
Massive divergence: The S&P and the benchmark US 10yr Yield
Coal miners used to carry caged canaries down into the mines on the theory that any presence of dangerous gases would kill the birds before the humans and serve as a warning for workers to exit the tunnels.
Over the years the term has evolved as a metaphor for early signs of trouble in the financial markets.
The Australian dollar (AUD)/Japanese yen(JPY) FX pair is probably the best-known benchmark of risk sentiment, with a well-deserved reputation as a leading directional indicator for markets in general.
On one side is the Aussie dollar, a liquid high-beta currency that is reflective of prevailing global macroeconomic trends, and on the other is the yen, best known as a reliable safe harbor destination in uncertain times. If that pair is rising (AUD outperforming the yen,) it most likely means economies are expanding, markets are happy and the outlook for asset prices favorable. If it’s falling (JPY outperforming,) the opposite. Simply, AUD/JPY is the ultimate canary in the Wall St. coal mine.
International trade and supply chain disruptions have taken a big bite out of global growth. Despite the slowing economy, expectations of even more central bank stimulus have kept financial asset prices elevated. But that fundamental divergence can’t go on forever. The Fed has some room to cut rates but in most other countries yields are already at historic lows while world-wide debt stands at record highs. Investors appear to be slowly coming to the conclusion that more of the same policies aren’t the answer. Either growth needs to accelerate or there has to be a reset lower in the financial markets. The breakdown underway in AUD/JPY is a sign that the canary is keeling over and that the latter outcome may be unfolding.
The AUD/JPY FX cross and the emerging market ETF (EEM) are both headed lower.
The re-election of Prime minister Modi and potential rate cuts from the Fed have been well received so far but the general softening in global growth remains a threat, especially to the emerging markets.
June 12th, 2019
I have joined the team at ConnectedtoIndia.com as a special contributor, providing market commentary with an Indian angle.
The euphoria in Indian stock markets after the recent reelection of Prime Minister Narendra Modi’s National Democratic Alliance could find further support next week if the US Federal Reserve decides to do an abrupt turn in its interest rate policy, from raising interest rates last December to possibly reversing that decision at its upcoming meeting.
Bombay Stock Exchange Photo courtesy: Wikipedia
A US interest rate cut would help provide assurances to India and the rest of the world that dollar liquidity in offshore financing markets will remain plentiful. This has already brought relief to market risk sentiment, at least for now. Despite some signs of profit-taking today, equity prices in general across all sectors are up sharply in the past week since the Fed hinted at the move.
Weak global economic growth made worse by intensifying international trade tensions is squeezing the finances of many export-dependent countries, drawing comparisons to the turmoil last year that began in the emerging markets and later spread to developed economies.
Currencies of China, Turkey, South Africa, and Brazil, where the first signs of trouble appeared in 2018, have recently come under pressure again. This has attracted the attention of central bankers, notably Federal Reserve chairman Jerome Powell, who are eager to head off a repeat performance in 2019.
Many countries, as well as corporate entities, took advantage of cheap dollar loans at low rates during the Fed’s easy money regime in the wake of the financial crisis of 2008. The resulting increase in leverage left these same borrowers negatively exposed as the Fed began to unwind those policies in earnest beginning in 2017.
Higher interest rates, declining liquidity, and a rising US dollar make that debt more difficult to service or roll over, precipitating a loss of investor confidence, potentially triggering a feedback loop of asset liquidation and in the extreme, lasting economic impairment.
The lesson of 2018 is of how fragile the global financial system remains despite the trillions of dollars deployed under central bank quantitative easing programs. Half of the USD5 trillion investment grade bond universe is now rated BBB, just one notch above junk status. A sustained economic downturn or an adverse credit event has the potential to unleash an avalanche of corporate downgrades and forced selling that would affect all markets.
Reserve Bank of India governor Urjit Patel was one of the first to raise the alarm over the unintended consequences of policy tightening by the Federal Reserve.
Just over one year ago, in a June 3, 2018 Financial Times op-ed Patel warned of the negative impact created by a dollar shortage across the emerging market sectors and urged the Fed to back off on plans to shrink its balance sheet.
He described the combination of balance sheet reduction and increased US treasury bond issuance (to finance tax cuts) as a “double whammy” threat that had essentially caused dollar funding in the sovereign debt markets to evaporate, sparking foreign capital outflows and leading to instability in currencies like the rupee.
The Fed listened. As a result, they will cease drawing down their balance sheet this September. And if prices in the futures market are any indication, the US could cut rates four times between now and the end of next year.
But is it too late and will it be enough? Terms of trade are being reshuffled on a global basis, and the effect on growth from disruptions to supply chains is still in the early stages and most likely underestimated. The risks ahead for India’s, and more broadly emerging nation’s, financial markets is that the extraordinary nature of these challenges falls beyond the control of not just the RBI but of all central banks, leaving India with one foot on shaky ground.
[The rupee and the Indian equity market are essentially the same trade right now as investors remain nervous over the entire emerging market sector. The prospect for easier policy from the US Federal Reserve has taken some pressure off of the rupee and its currency peer group for now.]
“The views expressed by the author in this article are personal and do not reflect those of Connected to India.”
Bond yields and commodity prices see a much different outcome than stocks.
June 10, 2019
Have you noticed that issues the Fed cares about are conditional and dependent on whether the stock market is going up or down? When the market is rising things like trade wars and weak price trends, while worthy of mention, are still considered “transitory” events. More annoying than scary. On the other hand, when the market is falling these same factors are considered full-blown threats to the economy.
Market action in the month of May and the Fed’s response is a good example of the latter. Even though the S&P had dropped nearly 8% from all-time highs, it was still up 9% on the year when Fed chairman Powell hit the panic button on June 4 saying the Fed was ready to act “as appropriate” to counter growing protectionist threats to the economy. See https://cnb.cx/2WaWNi5. Wink, wink. That’s all the markets needed to hear to launch six straight days of vertical ascent. Forget about why the Fed might be considering rate cuts: collapsing inflation expectations, potentially impaired corporate earnings or deteriorating credit, the fact that they are is all that matters. The playbook for equities remains the same as it has for the past decade: the bad news is (still) good news. As renown economist John Maynard Keynes once said, “the market can stay irrational longer than you can stay solvent”. So true.
But several reliable macroeconomic benchmarks don’t seem to be playing along. While stocks rip higher, bond yields and prices for copper and oil have barely budged off their lows. It appears that the economic outlook projected by the fixed income and commodity sectors is quite a bit less optimistic than what is expected in the equity space. The conflicting message between these two worlds might be temporary and meaningless or it could be something worth paying attention to.
At some point, the marginal utility of repeated deployments of the Fed put will begin to decline. I have no idea if that time is near but subtle market divergences like these will be the first sign that the game may be over. Therefore I will be paying attention.
The Strike Price on the Fed Put is A Lot Lower Than You Think
June 4, 2019
For anyone doubting the severity of the economic impact triggered by an escalating trade war, take a look at the ongoing collapse in the commodities and short term interest rate sectors. The CRB Index is on its way to getting flushed and Fed Funds futures are pricing in the possibility of four full rate cuts over the next 18 months. Any hope that investors had that tariffs and supply chain disruptions were just temporary inconveniences is now out the window.
The fundamental narrative is beginning to catch up to what the rate complex has been screaming for months. A report Monday showed US manufacturing activity slowed to the weakest pace in two years. See https://reut.rs/317v4m3 . In addition, the JP Morgan Global Manufacturing Purchasing Manager’s Index (PMI) posted its worst result since 2012, indicating an outright contraction in worldwide factory production. See https://bit.ly/2WiNqBS. But these are lagging indicators. It will get worse.
St. Louis Fed president Jim Bullard is the first voting member of the FOMC to break ranks with his colleagues, saying yesterday that “signals from the Treasury yield curve seem to suggest that the current policy rate setting is inappropriately high.” See https://cnb.cx/2WCogO8 . Most of the board probably agrees with him but given their history of decision-making don’t know how they’re now going to explain rate cuts with a 3.6% unemployment rate.
Herein lies the problem for the equity and credit markets. This last leg down feels like investors are beginning to suspect that the willingness of the Fed to deploy a safety net under the stock market, as they have in the past, is now a much bigger ask. The economy is decelerating quickly but it’s hard to sell that story given the ongoing strength in employment. There will have to be more pain. In other words, the proverbial Fed put is still in play but this time around it might come with a much lower strike price.
Commodities in big troubleInterest rates collapsing
A Trader's Perspective 