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Trading  | October 15, 2018

Authored by Nicholas Colas via,

A day late and a dollar short. That’s pretty much how we feel about Friday’s choppy rally. As we outlined last week, the typical bounce after a 4% decline (like Wednesday’s) usually comes in the next trading session. Not two days later. And, the average snap back rally is 1.7%. Not the 1.4% bounce we saw Friday.

Still, there were aspects of Friday’s advance to like:

  • A close near the highs of the day, although down from the open. We attribute that wrinkle to retail investor buying (see the Data section below) as that cohort tends to cluster their orders early in the trading day. So while technical analysts don’t like a close lower than an open, we’ll give Friday a pass on that count.
  • Stability in EAFE (developed Europe, Asia, Far East) equities, which closed the US trading session essentially unchanged (+0.4%).
  • A strong rally in Emerging Market stocks, +2.9% on the day.
  • Market leadership from large cap Tech stocks, +3.2% on the day (and 30% of its entire YTD gain of 10.8%).

Most of what we’ve read from the Street this weekend points to confidence that the worst of the selloff has passed. The anchor to this argument is the ferocity of Wednesday’s move, something that often signals a near term low. Since we remain positive on US stocks, we’d really like to believe this.

In the end, however, one indicator gives us pause more than any other: Treasury/TIPS breakeven inflation rates. A few numbers to frame the discussion:

  • The difference in pricing between plain vanilla 5-year Treasuries and inflation-protected notes with the same maturity implies a forward US inflation rate of 1.99%. While higher than the start of 2018 (1.86%), it is still well below May’s peal of 2.16%.
  • Go out to 10-year Treasuries/TIPS, and the current pricing implies future inflation of 2.12%. Again, this is higher than the start of the year (1.96%) but not a new high. That was set in May at 2.18%.

These statistics fundamentally challenge the notion that US yields are rising because of expectations for higher future inflation. If that were the case, TIPS spreads would be breaking out to the upside. But they clearly are not. Something else is going on.

We touched on this conundrum a few days ago, but it merits further attention. If inflation expectations were rising modestly, this would be a net positive for US stocks. Remember that revenue expectations for next year are at just 5%; a bump to inflation would help. Yes, there would be a lot of concern over margin pressures. But you only need to scan the S&P performance data from 1970-1979 to see that inflation doesn’t kill equity market returns. US stocks rose 78% in that decade.

So if it isn’t inflation expectations, what IS pushing US interest rates higher? Three possibilities (not mutually exclusive) fall to hand:

#1. The Federal Reserve is slowly reducing the size of its balance sheet rather than keeping it stable. This process started off slowly in 2018, with the Fed shrinking its holdings by an average $23 billion/month from January to June. In Q3 2018, that pace quickened to an average of $43 billion/month. Pulling that much liquidity out of the financial system may be pushing Treasury rates higher. Moreover, the Fed seems to have no intention of changing its current glide path.

#2. The US government will run a +$1 trillion deficit for the next 12 months, and likely for a lot longer than that. Yes, this is old news. And no, the US can’t “go bankrupt” as long as it pays its Treasury debt interest and principal in dollars. But it does seem fair for markets to ask for a better coupon in return for funding a country with an aging population and a 4-5% budget deficit/GDP ratio.

#3. A de-globalizing, tariff feuding world still owns a lot of US Treasuries, and America needs them to keep buying (because of Point #2). According to the most recent Treasury data, China and Japan still own over $1 trillion each of US sovereign debt. Hong Kong owns more than Saudi Arabia ($194 billion vs. $167 billion). As a whole, major foreign holders of US Treasuries currently own $6,252 billion and this is essentially unchanged from a year ago ($6,230 billion). In contrast, total debt has risen by close to $1 billion. And rates have risen…

Summing up: we worry the whole narrative about inflation expectations driving US rates higher is wrong. TIPS spreads would be rising if this were the right explanation. Instead, other factors are at play. And unlike inflation expectations, these might shift markets more quickly and without the reassuring message of “faster economic growth means higher inflation, but don’t worry too much about it.”

Our message: there’s still plenty to like about US stocks, but with rates holding the market’s attention we think there is still more volatility to come.

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