Posts published in June 2014
One of the many unusual exhibits on display in today’s asset markets is the seemingly tandem performance of U.S. stocks and bonds through the first half of 2014. Consider the two side-by-side charts below, both showing the price performance of the S&P 500 and the 20+ year Treasury bond. The leftmost chart depicts the trend from January 2012 to December 2013; on the right we see the 2014 year to date pattern.
The left chart is what we normally expect from the relationship between stocks and bonds: one goes up, the other goes down. Treasury yields soared in the first half of 2012 as the world still fretted over the uncertain fate of the Eurozone. In 2013 U.S. large cap equities had their best year since 1997, while bond markets went into a panic over the prospect of the Fed’s winding down its QE program. By contrast, these two asset classes have both enjoyed the investment climes of 1H 2014, causing a great deal of chatter and head-scratching among market participants. Should we expect this trend to continue? If not, which asset is more likely to fall out of favor?
All Quiet on the Correlation Front
As is often the case with short term asset trends there is less here than meets the eye. For one thing, there is not much difference in the correlation between stocks and bonds this year versus long term patterns. The fact of both assets moving in the same general direction this year would imply positive correlation. In fact, the YTD correlation between the two assets shown above, measured by rolling one month returns, is -0.75. That is actually a higher negative correlation than the -0.45 level for the 2012-13 period.
A closer look at the rightmost chart above should explain why this is so. While both stocks and bonds have gained ground this year, they have not done so at the same time. There have been a few classic risk on / risk off trades in the year to date, notably at the end of January when stocks experienced a 5%-plus pullback. There really is not much of a mystery here: stocks and bonds have benefitted from some of the same tailwinds (accommodative Fed, temperate inflation), but also from many independent factors.
Treasuries: Unlikely Yield Oasis
One of the distinct factors driving the bond market is foreign purchases of U.S. Treasuries. According to the Financial Times, foreigners hold a record $5.96 trillion, or just about half of the total volume of outstanding Treasury bills, notes and bonds. This is important: bear in mind that the Fed is reducing its own purchases of long-dated government bonds by $10 billion after each Open Market Committee meeting, taking $50 billion off the table since tapering began last December. Increased bond purchases by non-U.S. investors have thus stabilized bond flows, especially at the longer end of the curve. That helps explain why the U.S. 10-year yield remains far below where it started the year, while shorter term yields like the 2-year note are at or near their YTD highs.
And why are Treasuries so attractive to the rest of the world, given that rates are still far below historic norms? Partly because rates are even lower elsewhere. The chart below shows the yield spread between the U.S. 10-year and the Eurozone 10-year benchmarks.
.5% looks like a good yield when compared to 1.3%. On a risk-adjusted basis Uncle Sam would look even more attractive, given that Eurozone credits share a mix of the stable (Germany) and the shaky (France, Italy et al). In Japan, which shares with China the status of top global Treasuries investor, yields are even lower, and U.S. bonds offer the additional sweetener of a strong currency. The yen is about 17% lower today than it was at the beginning of 2013, thanks to an orchestrated weak currency policy. The Financial Times article cited above notes that the Japanese have bought $33 billion in Treasuries since mid-April – that alone more than makes up for the QE taper.
What’s In the 2H Tea Leaves?
Equities look expensive by historical standards; for example, the price-to-sales (P/S) ratio for the S&P 500 is currently at a ten year high. And credit market watchers are still waiting for what they see as the inevitable rise in rates as the Fed’s likely decision window of late 2015 to early 2016 approaches. It is possible that both asset classes could follow each other on a downward trajectory in the coming months – a reversal of the 1H pattern.
But don’t count on that as a given. For as much as stocks have risen virtually uninterrupted in the past two years, for as many days have gone by without large cap indexes being anywhere near their 200-day moving averages, the market is not yet exhibiting much in the way of final-stage bull rally characteristics. Volatility is tepid, intraday spreads are miniscule, and volume is consistently light. There may yet be another buying wave or two before the end of the year – though another 5%-plus pullback along the way would be far from surprising in our opinion.
On the bond side, we see headline macro data points as the most telling tea leaves. The Personal Consumption Indicator, the Fed’s preferred inflation gauge, clocked in at 1.8% for May. That’s nearing the central bank’s 2% target, and (as we noted in last week’s Market Flash) the Consumer Price Index is already above the 2% watermark. June unemployment numbers will be out in a couple weeks, and as earnings season gets into full swing we’ll see how companies are rebounding from the weather and other headwinds experienced earlier in the year. Stocks up, bonds down? No-one knows for sure, of course, but it may be a reasonable base case.
That ain’t workin’, that’s the way you do it…
Way back in the day, when Dire Straits composed their satirical riff on the easy-money world of MTV and rock celebrities, interest rates were still coming down from the double-digit rates of the early 1980s and the hangover of stagflation still gnawed at the minds of central bankers. The VIX index did not yet exist to serve as a barometer for measuring the market’s mood swings between fear and complacency. And the idea that central banks would take on a second life as the world’s largest sovereign wealth funds, buying assets in the open market in an attempt to prop up slow-growing economies, was scarcely imaginable.
Same Data, Different Tune
This week we learned that U.S. headline inflation is back over 2% year-on-year, with an even stronger annualized run when looking at the last three months. Prior to December 2013, the Fed had maintained that 2% inflation and 6.5% unemployment were levels consistent with a gradual move towards moving interest rates off their historically low floors. Now the numbers are there, but the tune has changed.
Of course, three months does not necessarily a sustainable trend make. But a majority of data points indicate that the second half of 2014 will see more robust growth than the first, with corporate earnings ticking into high single or low double digits and real GDP coming in above 3%. Yet Fed Chairwoman Janet Yellen, speaking after the Board of Governors meeting this past Wednesday, did everything in her power to convince markets that interest rates would not be coming out of their deep sea beds any time in the foreseeable future. In fact the tone she struck was notable for its lack of conviction in economic growth prospects. QE tapering continues – monthly bond buys are down to $35 billion – but the money is still free and the Fed clearly wants it to stay that way.
Central Banks, Yield Hunters
Meanwhile another news tidbit this week, courtesy of the Financial Times, focused attention on the new role of central banks as global fund managers, boosting their already expanded balance sheets with equity investments. The State Administration of Foreign Exchange, an arm of China’s central bank, is apparently the world’s largest portfolio manager with over $3.9 trillion in equity assets under management (including direct equity stakes in a number of prominent European companies). The FT article notes that central banks in Europe are also part of the action in embracing equities as part of a yield-hunting strategy.
What’s ironic – and not just a little troubling – about the idea of central banks as yield hunters and stock pickers is that they themselves are the architects and manufacturers of the free money, zero-yield world in which we live. As a matter of policy central bankers have sought to push investors out the risk frontier, hoping that the ensuing wealth effect would work back into the real economy. The first part of that equation has clearly worked – global equity markets are at all-time highs. Whether the rebound in GDP and employment is a direct result of the Fed’s nudge is up for debate. But it seems an odd time for central banks to be following their own advice and piling into risk assets, with potentially unfortunate consequences whenever this bull market finally plays out.
Gotta Move Them Color TVs
A closer look at the inflation numbers this month indicates price gains across a broad range of goods and services, signifying rising levels of demand. Admittedly the Personal Consumption Deflator, which the Fed prefers as its inflation barometer, somewhat lags the headline Consumer Price Index. But if the price trend of the past several months continues, Yellen’s Fed will come under increasing pressure to make some hard decisions about rates. Markets have followed a zig-zag course this year between yield plays – defensive sectors and high-dividend shares – and growth areas like small caps and technology. The next couple headline macro readings, along with 2Q sales and earnings results, will likely have a major influence on which trend plays out for the rest of the year. One would hope that the central bankers moonlighting as stock portfolio managers are ready for either outcome.
Summer weather has returned in full. For those of us who call the Mid-Atlantic region home, that means lots of humidity and the intermittent torrential downpour showing up just in time for the evening commute. It’s summertime in the markets as well. Average daily trading volume on the New York Stock Exchange for the month of June to date is about 17% lower than the average volume for the month of April. By the looks of things, not many people sold in May but they did go away, taking their algorithms and server platforms with them.
Light trading volumes are characteristic of many summers, though by no means all. Average NYSE trading volume in June 2011 was about 40% higher than the month-to-date figure for this year. Investors in 2011 were focused on the possible collapse of the Eurozone, and as the summer unfolded the debt ceiling debacle and S&P downgrade of U.S. Treasuries also conspired to keep money professionals from getting away to their favorite vacation destinations. In 2012 June was another busy month, but in early July that year ECB Chairman Mario Draghi uttered his famous “anything it takes” pronouncement to shore up support for still-beleaguered Europe. Average daily trading volume subsided from around 870 million shares in June to 740 million in July, and a listless 615 million in August (which is close to the 2014 June month-to-date figure of 605 million). Resort owners cheered Draghi.
While markets this summer are off to a calm start, there is no shortage of news stories with the potential to cause some near-term mayhem. The recurring 2014 theme of geopolitical flashpoints is back front and center today with Iraq seemingly on the verge of disintegration. The extremist Islamic State of Iraq and Syria is in the process of seizing control of large swaths of the country and converging on Baghdad, while in the north Kurdish forces have taken over the oil-rich city of Kirkuk. Oil prices predictably have shot up. Equities are down, though losses in most major markets are fairly contained. “X-factor” events like this have the potential to move index price returns well above or below 1% from the previous day’s close. That watermark is not being breached today; in fact, the S&P 500 has not experienced a daily gain or loss of 1% or more since mid-April.
Even a worsening of the Iraq situation, though, or a re-intensifying of other geopolitical problem spots such as Ukraine or the Senkaku Islands, is unlikely to keep traders from their beach houses or fly fishing meccas. At this point it would appear that the only thing with the potential to really shake up the current state of complacency would be a fundamental re-think of the baseline economic story. This story rests on several pillars: moderate growth in the U.S., avoidance of deflation in Europe, positive signs of a rebalancing Chinese economy, and healthy price trends in Japan (where headline inflation is now actually higher than either the U.S. or Europe). All with central banks at the ready where and whenever additional stimulus is needed.
It’s a strange calm, to be sure. Sometimes, looming clouds on a calm summer afternoon ominously portend a night of wild and devastating storms. But sometimes the clouds just sit there, and the calm continues.
If the European Central Bank had announced three or four years ago that it was preparing to drop its overnight deposit rate below zero, the Euro could easily have plummeted and yields on European benchmark securities would likely follow close behind. Negative interest rates are the latest frontier in the Wonderland of central bank stimulus tools – attempts to inject liquidity and stimulate enthusiasm for commerce in the absence of genuine organic demand.
So when the European Central Bank announced on Thursday its plan to reduce the ECB deposit rate to -0.1% the Euro…rallied, of course. We live in a different world now, a world where the logically predictable impact of any macro event is almost instantaneously offset by Algo Armies – trading bots with massive order volumes primed to take the other side of the trade. As the chart below shows, both the Euro and the 10-year Euro benchmark yield have been falling for about a month now as traders and hedge funds anticipated that the continuing string of low inflation figures in Europe would force ECB Chairman Mario Draghi’s hand. The Euro found a floor, though, and yesterday rebounded off the floor in the wake of Draghi’s announcement.
Up Is The New Down
The negative rate decision was just one of the policy measures announced yesterday – the ECB will also inject a package of cheap new €400 billion liquidity to encourage more bank lending, and begin to set up a framework for asset backed securities purchases to support small business initiatives – but it was the headliner. The idea of negative interest rates comes across as counterintuitive. You pay money to a bank for the “privilege” of opening a savings account at the bank. What’s next, the bank pays you negative interest on a mortgage, or a credit card? We’ll pay you to go to the mall – that’s the reductio ad absurdum of negative interest rates.
And yet, that is essentially the logic of the ECB’s move, and in theory it is not all that absurd. Year-on-year inflation in the Eurozone is running around 0.5% as of the latest May figures. With unemployment stuck in double digits there is not much evidence of the kind of natural demand that would lead to natural price increases. By charging banks to deposit money the ECB really is saying: don’t deposit money. Go out and lend money. Spend, don’t save.
Still On The Hot Seat
The problem is that there is very little empirical evidence to attest as to whether this creative measure will work or not. This is not the first time negative rates have been used: Denmark cut its deposit rate below zero for a brief time after 2012. But it is the first time the measure has been attempted as a key policy stimulus by one of the major central banks. Like the Fed and the Bank of Japan, the ECB has an inflation target in the neighborhood of 2%. Realistically, most observers expect prices to remain below those levels well into 2016, and will consider a baseline headline rate of 1.5% to be a sign that things are on the right track.
Meanwhile, Chairman Draghi and his colleagues will not be far from the hot seat in the coming months. A failure for inflation to gain some meaningful traction will renew calls for more aggressive stimulus measures, including a full-on commitment to the asset-backed bond buying program and other “traditional” QE measures (the quotes are because QE itself is anything but traditional, but it is now a mainstream tool of postmodern central banking).
If the ECB’s move had any impact on world equity markets yesterday it was near-uniformly positive, though at this point the rally seems to have a life of its own rather than any dependency on macro events to push it one way or another. It may be worthwhile to keep watch on trends in the Euro, though, and perhaps to hold Eurozone equity exposures not too far from neutral rate targets.