Sometimes there is no point couching things in a story, anecdote or fable.
This is a markets update – what the hell is happening out there?
Not long ago, and a few times before that, I wrote this:
“My base case for this year is that these rising inflation expectations show up first in bonds, then in stocks, causing both to sell off somewhere between quite a bit, and catastrophically.
The current trend in US government bond yields is a path to destruction, if the Fed continues to act as it is today.”
That was on January 25 of this year.
Four weeks later, and it’s now clear that the first wave has hit.
Bond investors have had their worst start to the year since 2015.
Fears about inflation hit bonds first – you can see the black line beginning to fall from the exact start of 2021:
Because inflation is poison to bonds. The coupon payment that bond holders get is directly, mathematically impacted by changes in inflation.
And inflation expectations, as measured by the TIPS market (Treasury inflation-protected securities), have been rising.
Last week, inflation expectations as priced by the market went higher than they had been since 2014.
You can see this here.
See how sharply inflation expectations have risen since the corona crash.
This affected bonds first, as you can see in the above chart, they’ve been faltering since 1 January.
And yesterday was their worst day in a long while, with ten-year bond yields spiking from 1.4% to almost 1.6%. They were below 1% when 2021 began – and have risen over 50% since then.
But in the last ten days, stock markets have finally caught the bug:
LQD Bond Index (black), Dow Jones (purple), S&P 500 (blue), Russell 2000 (yellow) and Nasdaq (red)
What can we learn from the above chart?
The black line is the bond index LQD. When that line is falling, that means bond prices are falling and yields are rising. This is because the yield is just a percentage figure showing the bond coupon as a % of the price.
Here are the basic points, in bullet point format.
- The stocks that correlate most aggressively to bond prices falling (yields rising) are tech stocks and small caps, shown by the red and yellow lines respectively.
- These are technology, growth, green, software, social media stocks and that kind of thing.
- The Dow Jones, which is more industrially focused, might actually benefit from rising yields.
- It is more heavily weighted to cyclical, or value stocks like construction, banks, oil and commodities.
Low interest rates (bond yields on government bonds) are helpful for companies whose profits are enormous, but a number of years away.
These stocks are more speculative, in the sense that you are speculating that future profits will be high – but you can’t say for sure yet. These companies are often quite debt-laden, as they aren’t yet financing operations with profit, or cash flow.
Meanwhile, rising bond yields reflect confidence in real economic growth, and so are beneficial for value or cyclical companies like some banks, construction or commodity companies because they participate most directly in the real economy, through lending, building and supplying.
As a result, it is natural that the most speculative things were hit hardest in the last two weeks.
You can see this in how clearly the four indices diverged in the last two weeks, as people finally realised yields were pushing much higher.
Another way to look at it is a very pure and powerful reversal of the growth vs value relationship which has seen growth stocks outperform value stocks consistently since 2009. Not this week…
It’s interesting to note that value stocks actually rose during the carnage.
This has meant that if you were just watching the broader indices, like the FTSE or the S&P… then you might’ve missed it.
But under the bonnet, a very powerful move was happening – mostly in the stocks which have performed best since the crash of last March, as I’ll show you in just a minute.
Why so sudden?
It’s odd. Lots of economic theory says that asset prices factor in all the available information.
But yields have been rising steadily since 4 August 2020, and inflation expectations have been rising steadily since the bottom of the crash in April.
But last weekend, suddenly inflation chatter was everywhere. On Twitter, in the Financial Times, on the BBC – hell, even on Instagram some accounts I follow were suddenly posting about it.
But one thing which may have slightly escaped our notice is that some of the market darlings have been struggling for a while now.
Tesla is now well below its most recent high, down more than a quarter since 25 January.
Big names in the solar and wind space – like Vestas, Orsted, or Sunrun – have fallen since the start of the year, almost perfectly in line with bond yields.
But the most speculative asset that crashed most spectacularly at the start of this week was bitcoin. Briefly down almost 25% in under 48 hours, it showed its power once more.
In the bitcoin space, I saw lots of people talking about things like Elon Musk’s tweet about its price being “quite high lol” lol: or Janet Yellen, US Treasury secretary, describing it as inefficient, speculative and used by criminals.
But to me the most significant factor is correlation and speculation.
Realisation crashed over investors like a wave last weekend, that inflation expectations were high and bond yields were following them up.
When speculation and greed are rife in markets, they tend to also be indiscriminate – ie, everything goes up together.
See below, how bitcoin has correlated with the best performing tech/growth stocks since last March:
What I find interesting here is that bitcoin’s pullback occurred in perfect tandem with Tesla, Vestas and Sunrun in January…. But Elon Musk’s tweets and Tesla’s announcement that it had bought $1.5 billion worth managed to push it into another hype-driven rally.
But as my colleague Boaz Shoshan has been warning so sensibly in recent months, if tech falters because of higher inflation expectations and bond yields, bitcoin will find it very difficult to carry on surging higher as it has done.
On Tuesday and Wednesday, Jerome Powell delivered the Federal Reserve’s six-monthly Monetary Policy Report.
He very carefully and deliberately focused on how the economy was not recovering that strongly, and how far away the US economy was from achieving the Fed’s two stated objectives: full employment and average 2% inflation.
He declared the Fed’s intention to push on with its asset purchases (currently $120 billion per month of bonds, both government and corporate) until those goals were in sight.
He also downplayed the risks of inflation, and asserted that the Fed has “the tools” to deal with inflation if it does spike later in the year as the economy reopens.
What does this mean?
It means that the Fed won’t shy away from supporting asset prices just because the TIPS market is pricing in higher inflation, and it means that the Fed will continue buying bonds, which applies downward pressure on bond yields.
So tech stocks, growth stocks, bitcoin and speculative favourite have steadied for now…
But the Fed is approaching a fork in the road.
If yields and inflation expectations continue to rise, it will have to decide between allowing higher inflation to drag bond yields higher… which would accelerate this sell-off in bonds and stocks.
Or, it will act to suppress bond yields, by implementing ‘Yield Curve Control’ – effectively more aggressive and targeted bond buying programs.
The former is very bad for highly valued assets. The latter, if successful, is good for them.
Investors must balance attack and defence, and try and be prepared for both outcomes.
What happens next? Well hopefully there will be some relief as things do look quite extreme in the short term, so a bounce of sorts is probably due in the bond and then stock markets.
But the speed of the move is frightening, as is the correlation of the downturn. Most stocks, bonds, gold – all have suffered.
This is a good time to reflect on your portfolio. Are you really as diversified as you think?
Are there ways you could protect your wealth even better? Will you survive another market panic?
Caution is, as so often, the watchword from here.
All the best,
Editor, UK Uncensored