The month of February has proved to be more interesting than expected. Last letter we wrote, we were focused on currency manipulation and the divergence between the ECB and US Fed. However, the month of Feb started with a bang, literally on the first day of the month.
Stocks closed out January 1.8% off its highs. However, by the 4th trading day into February, the market had seen a full-blown correction, touching 12% down on February 6th. So far, the market has managed to regain over 50% of that fall to be currently down 4.5% from its January highs.
The instigator for this panic in stocks has been the US interest rate market. In particular, the market has been focused on the US 10 year Treasury Note. It has been in a bull market for 30+ years, but recently has been very bearish. Effectively it has been a sellers market since Trump won the election in Nov 2016. The key level everyone has been eyeing is 3.08% which would be the level that breaks the 30 year bull run. The note touched 2.97% on Feb 15th and has consolidated around 2.9% since.
In a CNBC interview on Thursday 22nd, UBS’s Art Cashin noted that: “That 3 percent level is both a target and a kind of resistance. Everybody knows it’s like touching the third rail, the assumption is once they do it, all hell will break loose. So, we’ll wait and see. The sharp moves seen Wednesday were probably due to our friends, the long-lost ‘bond vigilantes’. We’re going to need a couple weeks to see if the bond vigilantes really are back or not, or whether it was simply a fluke. But remembering what bond vigilantes look like, it certainly had fingerprints on them.”
Bonds are quoted inversely, so as the bond is bullish, the yield on that bond is bearish. Hence, since Nov ’16 and more so since Sep ’17, the yield on the US government bonds has been increasing. There are several factors leading to this, but mostly due to the US Federal Reserve no longer a buyer of bonds, in fact they are actively reducing their balance sheet so are a seller of bonds. Combine that with the perception that Trump is positive for economic growth, along with the US Fed raising rates away from emergency settings, and we have yields gaining and will continue to gain.
The fall out to this is that stocks are no longer attractive for investors, certainly not at these elevated levels. The average yield return on the S&P stocks is currently 1.78%, down from its mean of 4.3%. Individual stocks may pay a higher yield but the US 10yr note is now a very attractive alternative investment.
Higher interest rates, or yields, also make it more expensive for corporations to do business, the margins are thinner. This too will have an impact on stock valuations and one has to question whether or not the US stock market is fair value at these levels. Considering the treasury market has not had a similar move, is the 50%+ bounce from the lows on Feb 6th warranted?
The focus for March will be this battle between bonds and stocks, but everyone will be very keen for FOMC on the 21st/22nd. High expectations of a rise is priced in, with the market looking for 0.75% – 1% increase this year. Will they get the first instalment of 0.25% on the 22nd? Will the Fed go 0.5%? We do not know but it will be very interesting to watch and my suggestion is to avoid US asset ownership running into that week, unless you really know what you are doing.