Having further digested and ruminated upon the offerings from Stool Yellen, listened to the "clarifications" from members of the Fed peanut gallery on Friday, and pondered goings-on elsewhere in the world, I have come to the conclusion that we may be in for a bit of a developed market equity correction.
Although I am not of the "OMG! Equities are soooooo expensive!" camp, by the same token I am cognizant that if interest rates were to trade at their long-term averages, then they (share markets) would be. And while the events of last week have hardly taken yields to long-term norms, they have at least given them a gentle nudge in that direction.
While normalization of rates is ultimately the best possible outcome for financial markets (in terms of functioning and the validity of the price signal, if not the actual level of prices), moves in that direction are likely to bring about the occasional speed bump.
At the same time, the world's most powerful financial actor, the head of the Federal Reserve, is a bit more of a wild card than first supposed. While I believe my earlier criticisms to be completely valid, at least Yellen can claim that her communication gaffes are not without precedent. Although younger readers may struggle to believe this, there once was a time when the Fed actually hiked interest rates. Unbelievable as it might seem, early in his tenure a certain Ben S. Bernanke was overseeing the completion of a tightening cycle inaugurated by his predecessor. He managed to surprise the market with his (gasp!) hawkishness in a somewhat cack-handed manner. The response?
A nearly 9% sell-off in the S&P 500, accompanied by a rise in yields. Sure, the underlying circumstances were different, but would you really be surprised by a similar outcome?
Credit spreads are already sounding a bit of a warning, moving to their widest levels since the taper was announced in December. Given the strong and understandable correlation with equities, does this really make you want to own equities a few points from the all-time highs?
In Europe, meanwhile, at least some measures of financial conditions have tightened measurably before the recovery has really gotten off the ground to any great degree. The euro TWI is comfortably above its 3, 5, and 10 year moving averages, which is hardly a recipe for growth for a current account surplus economy. At the same time, the ECB has presided over a bit of a rate hike this year.
No, they haven't performed an ill-timed hike in the refi a la the Trichet ECB, but their reluctance to do anything but sit on their hands and chit chat in the face of the decline in excess liquidity has pushed both EONIA and 3 month euribor 10+ bps higher; higher, in fact, that there were when the refi was half a percent higher than its current level!
Now admittedly, these yields levels are still very low, and it's difficult to see how a euribor rise from 0.20% to 0.30% is going to meaningfully restrict economic output. Well, other than helping to engineer a squeeze in the aforementioned trade weighted value of the currency....
Nevertheless, the money market squeeze, declining excess liquidity, and ECB inaction must come as a sore disappointment to those hoping for some sort of QE from Mario and co. After all, if they aren't willing to address the decline in the quantity of excess liquidity, they probably aren't going to do anything more esoteric, either. Given that surveys suggest a great deal of investor enthusiasm (and, one would posit, positioning) in European equities, it's not a great stretch to suggest that some length might be vacated on a down-trade. To my eye at least, the chart looks like it's rolling over, with some sort of head-and-shouldery formation on the Eurostoxx chart.
Finally, Japan has been a disaster all year, a veritable Godzilla rampaging through the portfolios of gaijin equity and macro punters. While it would be foolish to discount further action from the Kuroda BOJ, it is disappointing (to say the least!) that they have chosen to sit back and react to the aftermath of the consumption tax hike. Readers of a certain ripe vintage may recall that after the prior VAT hike in 1997, the economy and Japanese markets fell into a complete death spiral, ushering in the deflationary era that Abenomics is working so hard to eradicate. A little more proactivity would not have gone amiss!
While the Nikkei and TOPIX charts are bad enough, the really nasty one is the small cap Mothers index, a chart with virtually no redeeming qualities. Particularly worrisome is the massive uptick in volume accompanying the Q4 melt-up and subsequent meltdown. Perhaps we'll need to see markets become a little bored with these bad Mothers before they can rebound more sustainably. Indeed, observe how the tail-off in volume last summer coincided with the bottoming after the taper-tantrum meltdown last May.
(Needless to say, another weak China PMI will not help sentiment in Asia or anywhere else, for that matter.)
Now, does all this mean equities are going 20% lower, ushering in a new bear market and putting Yellen back in her more comfortable dovish perch? Not necessarily. However, most Fed chairmen have seen some sort of reasonable equity correction fairly early in their tenures, and it's difficult to see why the current Stool should be exempt. That Jeremy Stein suggested that the Fed should consider financial stability risks when engaging in an orgy of pro-growth policies is telling (though perhaps not as telling as if someone other than the resident financial stability hawk had said it!) It might, just might, suggest that the Yellen put (or, dare we say it, the Yellen payer swaption) might be struck a little further away than commonly supposed. And if that becomes conventional wisdom...well, it probably means that markets decide to have a test of exactly where the strike price is, does it not?
Although I am not of the "OMG! Equities are soooooo expensive!" camp, by the same token I am cognizant that if interest rates were to trade at their long-term averages, then they (share markets) would be. And while the events of last week have hardly taken yields to long-term norms, they have at least given them a gentle nudge in that direction.
While normalization of rates is ultimately the best possible outcome for financial markets (in terms of functioning and the validity of the price signal, if not the actual level of prices), moves in that direction are likely to bring about the occasional speed bump.
At the same time, the world's most powerful financial actor, the head of the Federal Reserve, is a bit more of a wild card than first supposed. While I believe my earlier criticisms to be completely valid, at least Yellen can claim that her communication gaffes are not without precedent. Although younger readers may struggle to believe this, there once was a time when the Fed actually hiked interest rates. Unbelievable as it might seem, early in his tenure a certain Ben S. Bernanke was overseeing the completion of a tightening cycle inaugurated by his predecessor. He managed to surprise the market with his (gasp!) hawkishness in a somewhat cack-handed manner. The response?
A nearly 9% sell-off in the S&P 500, accompanied by a rise in yields. Sure, the underlying circumstances were different, but would you really be surprised by a similar outcome?
Credit spreads are already sounding a bit of a warning, moving to their widest levels since the taper was announced in December. Given the strong and understandable correlation with equities, does this really make you want to own equities a few points from the all-time highs?
In Europe, meanwhile, at least some measures of financial conditions have tightened measurably before the recovery has really gotten off the ground to any great degree. The euro TWI is comfortably above its 3, 5, and 10 year moving averages, which is hardly a recipe for growth for a current account surplus economy. At the same time, the ECB has presided over a bit of a rate hike this year.
No, they haven't performed an ill-timed hike in the refi a la the Trichet ECB, but their reluctance to do anything but sit on their hands and chit chat in the face of the decline in excess liquidity has pushed both EONIA and 3 month euribor 10+ bps higher; higher, in fact, that there were when the refi was half a percent higher than its current level!
Now admittedly, these yields levels are still very low, and it's difficult to see how a euribor rise from 0.20% to 0.30% is going to meaningfully restrict economic output. Well, other than helping to engineer a squeeze in the aforementioned trade weighted value of the currency....
Nevertheless, the money market squeeze, declining excess liquidity, and ECB inaction must come as a sore disappointment to those hoping for some sort of QE from Mario and co. After all, if they aren't willing to address the decline in the quantity of excess liquidity, they probably aren't going to do anything more esoteric, either. Given that surveys suggest a great deal of investor enthusiasm (and, one would posit, positioning) in European equities, it's not a great stretch to suggest that some length might be vacated on a down-trade. To my eye at least, the chart looks like it's rolling over, with some sort of head-and-shouldery formation on the Eurostoxx chart.
Finally, Japan has been a disaster all year, a veritable Godzilla rampaging through the portfolios of gaijin equity and macro punters. While it would be foolish to discount further action from the Kuroda BOJ, it is disappointing (to say the least!) that they have chosen to sit back and react to the aftermath of the consumption tax hike. Readers of a certain ripe vintage may recall that after the prior VAT hike in 1997, the economy and Japanese markets fell into a complete death spiral, ushering in the deflationary era that Abenomics is working so hard to eradicate. A little more proactivity would not have gone amiss!
While the Nikkei and TOPIX charts are bad enough, the really nasty one is the small cap Mothers index, a chart with virtually no redeeming qualities. Particularly worrisome is the massive uptick in volume accompanying the Q4 melt-up and subsequent meltdown. Perhaps we'll need to see markets become a little bored with these bad Mothers before they can rebound more sustainably. Indeed, observe how the tail-off in volume last summer coincided with the bottoming after the taper-tantrum meltdown last May.
(Needless to say, another weak China PMI will not help sentiment in Asia or anywhere else, for that matter.)
Now, does all this mean equities are going 20% lower, ushering in a new bear market and putting Yellen back in her more comfortable dovish perch? Not necessarily. However, most Fed chairmen have seen some sort of reasonable equity correction fairly early in their tenures, and it's difficult to see why the current Stool should be exempt. That Jeremy Stein suggested that the Fed should consider financial stability risks when engaging in an orgy of pro-growth policies is telling (though perhaps not as telling as if someone other than the resident financial stability hawk had said it!) It might, just might, suggest that the Yellen put (or, dare we say it, the Yellen payer swaption) might be struck a little further away than commonly supposed. And if that becomes conventional wisdom...well, it probably means that markets decide to have a test of exactly where the strike price is, does it not?
9 comments
Click here for commentsGood post. Do you have a natural bearish bias? We need forward guidance on this. I'll be watching like a hawk to discern any trends for future reference.
ReplyMoar charts :)
ReplyThere are very good technical reasons for developed equity markets to do some back and fill this year, plus the ridiculously lopsided bullish sentiment we started the year with has not even begun to get shaken out yet IMHO
C Says
ReplyI think you read C's short let's find a reason for that :)
Seriously now, the very big problem with this recovery and it's aftermath of tightening policy is the relationship between real incomes and the additional costs that would necessarily be incurred by even relatively small rises in finance costs.Historically rising rates have been correlated with improving conditions and the latter have been accompanied by rises in real incomes and of course with those have come better risk conditions in terms of being able to service existing debt and take on more of it.
Now if we consider the above have we yet seen that change in incomes necessary for all the rest to apply?
I'll leave you to answer that for yourselves ,but I'm short because I don't believe conditions are yet able to absorb the consequences of tighter policy.
Following dissapointing Chinese pmi , the aussie and asx continue its march on anticipation of rrr cut. Must have miss your memo.
ReplyC Says
Reply"Following dissapointing Chinese pmi , the aussie and asx continue its march on anticipation of rrr cut. Must have miss your memo"
Except that isn't a trend ,it 's a churn.
i agree 200% but i have been short (Europe) for a while already, right after they printed a lower high following a US all time high, which is always a sign of caca to come.
Replyin your scenario- you think long yen (esp eurjpy) is still the insurance policy to have for downside moves in DM equities?
ReplyI am surprised that you are surprised by the JCB's inaction. Their previous speech was quite clear that 1) they were satisfied with their policy so far and 2) they already expected that the sales tax hike was going to slow economy for a few months, then they believed that it would come back to the trendline on its own. It meant that they saw no need to QE at the time. They might well change their mind now given such a hawkish Fed. But you cannot say that JCB's inaction was unexpected.
Reply@hotairmail: I have no natural bias other than a desire to call the market correctly.
Reply@ anon: I view the BOJ's actions as a parent might upon seeing a 'satisfactory' grade on a child's report card. Technically it's OK but you really expect better.....