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Good morning. I spent a long, pleasant weekend in sunny Miami doing some serious research FT Globetrotter‘s guide to the city. But what do I find on my return? The market drove me crazy again. Last week, it seemed to me that Jay Powell and the Federal Open Market Committee had managed to update the market without scaring it. Now, the market now looks very scary. Yesterday, bonds sold hard and shares experienced their worst day since May. I need to stay home more often. Email me: email@example.com
Reflection redux, hopefully
What put the scare in stocks? The suspect is the good rise on the long side of the yield curve. The sharp rise in interest rates that has been with us since the beginning of August has accelerated rapidly (all graph data from Bloomberg):
Here are the changes in the curve since the Federal Reserve meeting on Wednesday last week:
This is a fairly stiff and fairly uniform increase over the waist and the long side. Are we going back to the levels reached this spring, when the reflection trade dominated the markets, to the great delight of Wall Street? What has changed since the markets’ quiet initial reaction to the Fed’s announcement last week?
Hawk sounds of the Bank of England, plus ebb panic over Evergrande’s balance sheet, may have created a world of higher rates and inflation suddenly seems more likely. The price of Brent crude oil, which recently exceeded $ 80, may also have played a role. Or it could be none of that. Sometimes even the bond market just takes time to see what’s in front of its nose.
As I indicated on Thursday last week, the market is initial tranquility oddly equal. Economic growth above the trend for next year is at least still the consensus expectation, house prices fire and wage bubble. The Fed has told us that it is about to slow down the pace of its mortgage purchases. And yet there are real rates rising, but still far below zero:
What this chart tells me is that space rates can rise. There should be a rising inflation risk premium there, given how inflation data have developed over the past few months. Real yields should also anticipate the expectation of a large buyer from the bond markets. Why should real returns still be negative?
I spoke to Bob Michele, Chief Investment Officer and Head of Fixed Income at JPMorgan Asset Management, and he summed up my feelings precisely:
‘I think there have been three things going on in the last ten days. The central banks as a whole – not just the Fed but the Bank of England, the Reserve Bank of Australia and others – are approaching a policy shift and a start to decline. We see a total of $ 300 billion [monthly] buying bonds at all the central banks, and you should expect things to change as they leave. An actual return of minus 1 percent is not normal. It is an artificial construction of the central banks.
“[Then there is a] recognition that reopening [price] pressure does not go away quickly – bottlenecks, energy prices, container ships stacked, the labor market. It’s going to take years, not months, and in the meantime things will cost more to get things done.
‘The third thing is the debt ceiling. Does anyone step back and realize that you are having a debate about the debt ceiling because a lot of debt is being issued, and many more will be issued? This is a wake-up call. . . who is going to buy it [debt] if the central banks withdraw? People like me, and I’m not going to buy government debt at a negative real return. ”
Here’s how I would sum up. The only way to think that real returns can stay negative is if you think growth is disappointing, or the Fed is going to slow down and slow down the slowdown and slowdown, or both. Otherwise, it seems to me that there is only one way to raise interest rates – and the important question is whether it rises or rises. If they fall, it can be good for risk assets. Peaks tend to cause messy re-prices as investors decline.
Equities have certainly not responded well to the recent rise in rates. Many market observers say that the valuations of shares are ‘on a low-rate basis’. That is, low interest rates have to increase stock prices mathematically, because these are the rates at which future cash flows are discounted. This is true as far as it goes. But much depends on what drives the rates higher – a strong economy or just inflation. In the former case, and not the latter, higher future cash flows help offset higher discount rates. Another trade in reflection may just be good for stocks. Not so stagflation.
So look at the performance of economically sensitive value stocks. If we get the benevolent interest rate hikes, which are largely driven by economic growth, one would expect the value to perform well in terms of technology and other growth stocks, and at least keep their absolute terms, as in the spring. Here is the Russell 1000 value and its growth counterpart, at a yield of 10 years:
While the value so far has been better than the growth in relative terms as yields have accelerated upwards, it has at best moved sideways in absolute terms. It looks more like stagflation than reflection, but it’s early days.
A good reading
Fed Guy’s Joseph Wang Blog Makes It Simple But Interesting point. The Fed has kept rates low to maximize jobs. But another effect of low interest rates is to increase the wealth of the upper half of the distribution of wealth (and especially the upper quarter). This can make these wealthy people less likely to work because their homes and their stock portfolios have made them rich (or at least richer). Here is Wang’s lock pair:
‘The Fed seems confused by the labor market: there are many signs of a labor shortage, although the unemployment rate is also high. The Fed keeps rates low in the belief that the economy is far from maximum work, even though inflation is high. But if the ‘wealth effect’ has structurally changed the labor market, the Fed is looking at the world through an outdated model. It can require much higher wages to reach the unemployment rate before the pandemic. ”
I need more time to think about this argument, but I like that it drops a very popular view on its head. Many people think that fiscal policy has taken away poor people’s incentive to work. But what if the real problem is that monetary policy has made rich people lazy?