The fight between bulls and bears over the US economy and markets has just begun
Fund outflows from US equities, rising yields on 10-year bonds and increasing odds of four rate increases this year because of mounting inflation fears have set the scene for a showdown between bulls and bears
The reverberations of the recent surge in volatility in financial markets have just begun.
Despite a strong rebound in US stocks over the past fortnight, international investors continue to withdraw money from the country’s equity funds, with redemptions of US$2.4 billion for the week ending February 21, bringing total outflows since the start of this year to US$22 billion, according to EPFR Global, a data provider. While the threat of higher government bond yields is weighing on US equity markets, European and emerging market stock funds attracted a further US$3 billion and US$5.4 billion respectively last week, according to data from JPMorgan.
America’s debt market is also under increasing strain, with the yield on the benchmark 10-year Treasury bond hovering near the psychologically important 3 per cent level, fuelling speculation that the 30-year-long bull market has finally come to an end. Following last Wednesday’s publication of the hawkish minutes from the Federal Reserve’s January policy meeting, the odds of four interest rate increases this year – at least one more than the Fed anticipates – have shot up to 27 per cent.
Add in an inflation scare and mounting concerns about the US fiscal position following the enactment last December of sweeping tax cuts and a deficit-swelling budget deal agreed earlier this month, and it is clear that US markets and the economy have become the battleground between bulls and bears.
While overstretched valuations in US stocks and bonds were a focal point of investor anxiety long before the bout of turbulence swept through global markets earlier this month, the fact that the trigger for the surge in volatility – a sharper-than-anticipated pickup in wage growth which accentuated fears about inflation, pushing up bond yields – emanated from the US has sharpened the focus on financial and economic developments in the world’s largest economy.
Last Thursday, Steven Mnuchin, the US Treasury Secretary, urged investors not to worry about the inflationary and fiscal consequences of the tax cuts, even going so far as to claim that “you can have wage inflation and not necessarily have inflation concerns in general”.
While some prominent bond investors, including Jeffrey Gundlach of DoubleLine Capital, a hedge fund, are ridiculing Mnuchin for downplaying the inflationary threat, the fact remains that the jury is still out as to whether the recent rise in inflation and bond yields are a foretaste of things to come that will force the Fed to turn more hawkish and mark a definitive end to the rally in equities.
Make no mistake, the US inflation scare, as I argued in an earlier column, is the single most important driver of global markets this year and the crux of the debate between bulls and bears.
In defence of the bulls, inflation is hardly getting out of control. The 10-year-implied forecast for US consumer prices derived from the bond market shows that inflation, at just over 2 per cent (on a par with the Fed’s own target), is still within its range over the past five years when fears about deflation were rife. However, real bond yields – yields adjusted for market expectations of inflation – have risen sharply this year and are now at their highest level since 2013.
This suggests that the real worry is not inflation but rather the fear that the Fed, under its new chair Jerome Powell, will overreact to the threat of higher inflation.
On Tuesday, Powell will have a chance to clarify the Fed’s position when he testifies before Congress. If the new Fed chair sounds a more hawkish note – a distinct possibility given the mounting upward pressures on inflation – the probability of four rate hikes this year will keep rising, pushing bond yields up further and putting US equity markets under renewed strain.
Yet just because volatility has returned to markets does not mean that the world’s leading central banks, in particular the Fed, are about to get a lot more hawkish.
Powell, who is nicknamed “Yellen 2.0” because of his strong support for the dovish policies of his predecessor, Janet Yellen, is very unlikely to depart from the Fed’s gradualist approach to raising rates. The last thing Powell needs right now is a disorderly Fed-driven sell-off so soon after a change in leadership at the central bank.
Even if the 10-year Treasury yield surpasses the supposedly critical 3 per cent level, insightful research from Credit Suisse shows that US equities have risen in tandem with rising yields over the past two years, and that it is a 3.5, or even 4, per cent 10-year yield that is the key threshold.
The bears are finally giving the bulls a run for their money. But it will take more than a sudden burst of volatility for the bears to gain the upper hand.
Nicholas Spiro is a partner at Lauressa Advisory