by Jim Welsh
Macro Tides Monthly Outlook for December 2017, Part 2
See Part 1: Will Santa Deliver Inflation To The Fed?
The Rise of the Bond Vigilantes in 2018
In 1993, James Carville an advisor to President Clinton said:
“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
Please share this article – Go to very top of page, right hand side, for social media buttons.
With the inception of Quantitative easing in 2008, the Federal Reserve tamed the bond vigilantes in the U.S. and sent them into hibernation. The Bank of Japan in 2012 and the ECB since 2015 have made sure the bond vigilantes were kept sleeping in their lair. Central banks have successfully suppressed long term interest rates in large part because the goals of the central banks and international bond investors were aligned.
As discussed in the September Macro Tides:
“When the Fed and ECB wanted to repress interest rates they could enlist the help of market participants to ride their coattails since investors would profit from the collaboration. Unwinding negative real interest rates and curtailing bond purchases will cause interest rates to rise and create losses for bond holders. Rather than being coconspirators, market participants will be combatants with the central banks and more importantly with each other.”
This is a significant change which has yet to manifest itself but is likely to emerge in 2018 as the bond vigilantes reclaim a role in the global bond market.
The Federal has been able to pursue a gradual approach since December 2015 since inflation remained comfortably below their 2.0% target. As Dallas Fed President Robert Kaplan said:
“I would like to avoid a situation where the FOMC is playing “catch-up” in raising interest rates.”
The additional stimulus provided by tax cuts increases the risk the Fed could find itself playing catch up since the stimulus will add to inflationary pressures that are already apparent. The rally in the stock market in response to the Senate’s approval has stretched the market’s high valuation further. In Kaplan’s view “financial imbalances have the potential to threaten the sustainability of the expansion“.
The increased risks from inflation and financial imbalances suggest the Fed is likely to increase rates more in the first half of 2018 than the Treasury market is expecting. According to Bloomberg, the probability of the Fed raising the federal funds rate in December and 4 more increases in 2018 is less than 6%. This could be the ideal set up to awaken the bond vigilantes in the U.S. that have been hibernating for years.
In this scenario, the yield on the 10-year Treasury bond will pop above the March 2017 high at 2.62% and likely test the high of 3.03% from December 2013. From the bottom in July 2016, the 10-year Treasury yield rose from 1.336% to 2.62% or an increase of 1.28% for wave A. The decline from 2.62% in March 2017 to 2.034% in September 2017 represents wave B. If wave C is equal to wave A and rises 1.28% from the September low of 2.034%, the 10-year Treasury yield could reach 3.30%. This suggests that a test of the December 2013 high is probable.
I suspect that yield hungry pension funds and insurance companies would be aggressive buyers as the 10-year yield approaches 3.0%. At a minimum, a tradable rally could commence from near 3% that might be able to bring the 10-year yield down to 2.62% – 2.40%, even if the yield eventually reaches 3.30%.
The 30-year Treasury yield will test and likely breach the March 2017 high of 3.20%. The yield pattern in the 30-Treasury bond suggests the following: From the bottom in July 2016, the 30-year Treasury yield rose from 2.10% to 3.20% in March 2017 or an increase of 1.210% for wave A. The decline from the high at 3.20% to 2.034% in September 2017 represents wave B. If wave C is equal to wave A and rises 1.10% from the September low of 2.65%, the 30-year Treasury yield could reach 3.75%.
This suggests that the December 2013 high may not get tested. Pension funds and insurance companies might get excited about the opportunity to buy the 30-year Treasury bond if the yield rose to 3.75%.
ECB’s Bear Trap Grip on the European Bond Market
The combination of Quantitative Easing and a policy rate of –0.40% enabled the ECB to suppress interest rates more severely than the Federal Reserve. Five year government bonds in Germany, France, and the Netherlands sport a yield that is below 0% so trillions of sovereign bonds throughout Europe have a negative yield. The U.S. 5-year Treasury yield is 2.15%. The Bank of America Merrill Lynch (BAML) Euro High Yield Index was 2.08% at the end of October and now yields of 2.51%, not much more than the 10- year Treasury bond which yields 2.38%.
The ECB will reduce its monthly bond purchases from $60 billion to $30 billion beginning in January and plans to continue that pace through September 2018. At the ECB’s October meeting the ECB retained the link between asset purchases and inflation, stating purchases will continue until inflation moves closer toward its 2.0% target.
That may change according to ECB board member Benoit Coeure who is the head of operations at the ECB. In a November 21 interview he said:
“I expect this link to change when the governing council is sufficiently confident that net asset purchases are less needed for inflation to return towards 2 percent in a sustainable way. We were not ready to make that change in October, but I expect it will come at some point between now and September 2018.”
In order for this important change to occur, the ECB will need to see that measures of inflation and inflation expectations are rising and nearing 2.0%. The ECB will also want to be confident that economic growth is holding above 2.0% and likely to continue to put upward pressure on inflation. Inflation expectations in Germany jumped from a low in mid 2016 to a high in February 2016, before pulling back into July 2016. It is noteworthy that the July low was comfortably higher than in mid 2016 and the trend has been gradually up since then. The pace of the increase since July 2017 looks far more sustainable than the sharp rebound from the low in mid 2016.
Mr. Coeure also stated:
“The governing council must be confident that monthly asset purchases are no longer as important in reaching the ECB’s inflation target and keeping it there.”
It is likely the ECB will need to see inflation expectations rise to 1.80% and hold near 1.80% for a number of months before the ECB will have the confidence necessary to make that change.
Confidence will be bolstered if economic growth holds above 2.0% which seems likely in early 2018 based on recent reports on manufacturing and Eurozone Consumer Confidence and Economic Sentiment. The November IHS Markit Manufacturing survey for a number of European countries set multi-year or record highs. The November Surveys of Consumer Confidence and Economic Sentiment were at the highest level since 2007. If growth carries through the first quarter and inflation expectations move higher, the ECB may consider changing its inflation language during the second quarter.
Whenever this change is made it has the potential to wake up the European bond market to the inevitability of the ECB winding down its QE program and the repression of European bond yields. If GDP growth is above 2.0% and inflation is closing in on 2.0%, why would anyone want to own a German 10- year Bund yielding less than 0.50%? This is the existential question bond managers in Europe and globally will ask themselves in the first half of 2018. This will lead them to decide to lower their European bond exposure before the ECB announces it is stopping its QE purchases and the urge/stampede to sell develops.
The ECB will use its forward guidance in advance of September 2018 to ‘manage’ the potential volatility that could arise so bond managers will try to front run this announcement. An important clue that this is beginning will be provided when the yield on the 10-year German Bund closes above 0.50%. My guess is that this is likely to happen before June 30 and could be followed by an increase to 0.75% or 0.90% fairly quickly. If the 2.0% spread is maintained between the Bund and 10-year Treasury bond, a rise in the Bund to 0.75% would result in the 10-year Treasury yield breaking out above the March 2017 high of 2.62% and potentially lead to a test of the December 2013 high of 3.03%.
Stock Market
The S&P 500 has rallied from the March 2009 low of 667 to a high of 2567 on December 4. Roughly 60% of the increase is due to the rise in corporate earnings from economic growth and financial engineering from stock buybacks. The remaining 40% has come from investor’s willingness to pay more for each $1 of earnings which has increased the S&P 500’s Price Earnings ratio from under 12 in 2011 to almost 18 currently. Most measures of valuation indicate that the market is expensive.
For a Federal Reserve president to specifically reference the market’s valuation and lack of volatility is truly extraordinary. That said valuation is virtually worthless as a ‘timing’ tool since valuations are driven by emotion and investors typically become too optimistic at tops and too glum near market lows. Valuation has been a valuable tool though for estimating future returns. As the market becomes more expensive future returns are lowered.
Based on the market’s current valuation, the estimated return for the next 10 years is less than 2% annually. At the low in March 2009 Equity as a percent of Household Financial Assets was less than 34%, and the 10-year estimate for the 10-year rolling return for the S&P 500 was over 15% a year. Household equity is up to 56% which is comparable to the high in June 2007 and 1968. Both of those periods were followed by significant bear markets. Although the current allocation is less than in 2000 it is important to remember 2000 was the top of a mania in dot.com stocks which shouldn’t provide much comfort.
Since July 1 the S&P 500 has climbed from 2410 to 2765 an increase of 10.4% in less than six months. The big move in such a short time has not gone unnoticed. The volume of searches for ‘how to buy stocks’ on YouTube has quadrupled since July.
It is important to note that valuation is not a reason to sell stocks or why the stock market consistently declines after a period of high valuation. Severe bear markets occur when the economy is threatened by recession and the market is richly valued. A recession is not likely in the next six months, but the market could be at risk of a 7% to 10% correction in the first half of 2018 if the yield on the 10-year Treasury bond exceeds 2.62%. Many strategists cite the low level of interest rates as justification for the market’s current valuation. If rates rise, the S&P 500’s P/E ratio is likely to decline which by definition would translate into lower stock prices.
Prior to the onset of the next bear market I expect the technical underpinnings of the stock market to deteriorate 3 to 6 months before the S&P breaks down. There has been some deterioration as the percent of stocks above their 200 day average has slipped from 68% in mid October to 60% on December 5 even as the S&P 500 has pushed to a new all-time high.
Overall, the internal strength of the market is good since my proprietary Major Trend Indicator is still positive and the Advance / Decline line has confirmed the new high in the S&P 500 by also making a new high. Prior to the 15% correction between July 2015 and February 2016, the Major Trend Indicator had been weakening for months, the percent of stocks above their 200 day average was less than 45%, and the Advance / Decline line was trending lower. The uptrend in the market is likely to carry into the first quarter.
