Implied volatility in the equity markets (VIX) spiked above 15% at the start of this quarter and while the peak did not match February’s 50%, it has been far more persistent. The VIX is now in its longest continuous period above 15% since 2011. There are two major sources of uncertainty that is causing the surge in volatility: concerns that the growing trade tensions with China could trigger a significant slowing in US economic performance and the prospect of higher U.S. rates as the Fed reverses the last decade’s unprecedented monetary expansion. It seems odd for the market to simultaneously be concerned about weaker growth and higher interest rates; we believe it is the difficulty of foreseeing which of these themes will dominate that is making sentiment so unstable.
The interplay of negatives for growth with the positives for rates is manifest in a flattening of the yield curve. A key factor in this week’s market selloff is that as shown in figure 1 from the Tradeweb rates view in Eikon one point of the curve, the 2Y vs 5Y US Treasury spread, has inverted. There is a conventional view that yield curve inversion is a precursor of a recession and a bear trend for equities. Recent experience gives credence to this belief; as shown in the accompanying chart, the 2vs5 spread inverted ahead of both the dot com bust as well as the Great Recession. But we believe that it is too soon to start looking for a major market downturn on this basis, in part, because the prior inversions were more pronounced extending out to the 10Y part of the curve. So far, the 2Y vs 10Y spread has not inverted. Moreover, the inversions in figure 1 emerged at least a year before the market went into recession. Indeed, in both cases the curve had dis-inverted by the time the downturn occurred. History suggests an inversion now is a reason for concern about 2020 not 2019. On the other hand, prior to the dot com bubble recessions accompanied by bear stock trends have emerged in the absence of an inversion so it cannot be ruled out that overly tight monetary policy, trade disruption or other shocks could trigger a recession.
Figure 1: U.S. Treasury Bond Yield Curve
Is the Fed more bark than bite?
Expectations of continued Fed rate hikes are buoying the front end of the yield curve and there is clearly concern that the Fed might overdo the tightening. But history suggests that while conditions are tightening there is still much room before rates are high enough to be a trigger for an economic downturn. The Fed began raising Fed funds off the zero floor at the end of 2015 and, as shown in figure 2 the rate reached 1.25% by the middle of last year. Since then a steady dose of rate hikes has taken Fed funds another 1% point higher. At the same time, the Fed has been reversing quantitative easing as it has not rolled over the roughly $30 billion average amount of Treasury bond holdings that are maturing each month – but the flat curve suggests this has had little impact on long-term rates. The market looks for more tightening next year though expectations have moderated recently from three 25 basis point hikes to only two. The moderation reflects growing perceptions that with global growth slowing, less tightening is required to constrain inflation and moderate growth and there are also concerns that the U.S. Administration’s focus on trade restrictions could also begin dragging on growth. In addition, Fed Chairman Powell in a recent speech made comments suggesting that Fed funds was close to a neutral level – e.g., neither providing stimulus nor constraint – and the Fed’s decision on hikes next year would be guided by the economic numbers – in contrast, the Fed this year clearly indicated they were on a steady quarterly rate hike path.
Figure 2: Market expectations and actual value of the Fed funds rate
As already indicated, the market has reduced the amount of hiking expected for next year and, at this juncture, is not pricing in any hikes in 2020 so the market is pricing this tightening cycle to max out by the end of next year. The fact that the market is looking for rates to peak out by the end of 2020 implies that the Fed will have done enough – or other factors will slow growth – to reduce inflationary pressures. As noted above, much of the market worry revolves around the possibility that the Fed will push rates too far triggering economic recession.
Keeping it real
Figure 3 creates a filter on market performance and puts it into the context of the cyclical history of Fed interest rate policy. The focus in this chart is the real value of Fed funds – deflated by trailing year-over-year CPI inflation. A market downturn is specifically defined as two consecutive months where the SPX was down at least 10% on a year-over-year basis. The triangles on the SPX line in the chart indicate those periods when the consecutive 10% rule is satisfied. The rectangles denote the period from the prior market peak until the last triangle in a series of declines – i.e., an indication of peak to trough for a major market dip. The red line in the chart represents when the real Fed funds rate is above 150 basis points. The market declines since 1990 roughly align with figure 2 and in all three cases the real rate of Fed funds was well above 150 basis points. But unlike the curve inversion, the 150-point real fund barrier has been a key precursor of market downturns going all the way back to 1960. The only exception was the 1978 slump that was triggered by an OPEC manufactured surge in global oil prices and the responsive dip in the market occurred with real Fed funds still in negative territory. It should be noted that with the exception of 1978, real Fed funds above 150 basis points has been a necessary condition for a major market downturn – as defined by the 10% criteria – but is not sufficient. There have been years – especially in the 1980s – when the market trended higher even with real rates above 150 basis points. The key implication is that with real rates at roughly zero, history says there needs to be a significant combination of higher nominal rates or lower inflation before conditions are in place for a sustained decline in equity markets. For all the talk about Fed tightening and nearing neutral, by historical standards monetary conditions cannot be deemed even close to tight.
Figure 3: Real Fed funds rate and SPX market peaks
That said, there is modest risk that further deterioration in U.S. trade relations, particularly with China, could serve as a strong enough dislocation to trigger a major market decline and economic recession but this seems unlikely. Like a major move in oil prices, the trade disputes are apt to have major impacts for specific industries but there will be winners and losers so the net impact on overall growth should be modest. While the implication of comparative advantage suggests there is a net negative from trade disputes, this impact will take years to have a meaningful impact. In the short run, the most likely way trade distortions will be manifest at a macro level is in rising prices. But so far there has been no meaningful effect on inflation rates.
Cross market allocations raise some warning signs of trouble
Figure 4 compares U.S. portfolio manager allocations in global portfolios to stocks, bonds and cash. The most significant evolution has been an increase in allocations to cash instruments from a low of 1.8% in June 2017 to almost 6% at the end of November 2018. This is probably, in part, a reaction to higher short-term interest rates, but the move into cash largely came out of alternative assets – e.g., hedge funds – which likely also reflect the well reported sustained underperformance of Alternatives. More worrisome is the 2% shift of funds out of equities and into bonds. This is exactly the reallocation one would expect if the market was positioning for a peak in rates that would occur at the end of a Fed tightening cycle, so continuation of this trend might indicate that contrary to history, a bear market could develop in the absence of the historic interest drivers.
Figure 4: Portfolio allocations of U.S. Institutional Investors
The patterns of credit spreads are also starting to show some signs of market stress. Figure 5 shows the SPX in conjunction with the spread between the maturity-weighted average of BBB corporate bond rates vs the U.S. 10Y Treasury rate. There is a long history of a link between credit spread widening (note the spread data in the chart is inverted) and declines in the equity market. More specifically, the spread tends to tread in a range of roughly 60 to 175 basis points and breaks above 175 and, especially, moves through 200 are generally associated with significant declines in the stock market. The spread is pushing the upper end of the range which is a warning sign that history may not repeat itself and we will see a bear market emerge without the prerequisite interest rate configurations. But at this point the spread is a reason for caution, but is not yet signaling a major downtrend in equities.
But the absence of a bear does not equal a bull. While we think the market is exaggerating the implications of Fed tightening and trade disruptions, growth is likely to slow which could negatively affect corporate earnings weighing on equity market performance. While it seems premature to look for an extended bear market, it also seems unlikely that the market will achieve significantly new highs. It could well be that the environment of the past two months of high volatility with little net movement could be indicative of what to expect in 2019.
Figure 5: SPX and BBB Corporate vs. US10Y Bond Rate
The Bottom Line
For all the talk of Fed tightening, by historical standards, monetary conditions are still not tight enough to signal the beginning of a sustained market decline. More specifically, a 2Y vs 10Y government bond inversion and Fed funds hitting 150 basis points in real terms are two prerequisites for sustained market downturns which have yet to be achieved and the downturn normally does not emerge for at least a year after these conditions are met. That said, there are some worrisome developments that should be monitored. The Refinitiv survey data indicates that there is a gradual shift out of stocks and into bonds by U.S. portfolio managers and BBB spreads over Treasuries are pushing against the top of the trading range. Continuation of the portfolio shift or the BBB spread breaking 200 basis points would warrant turning extremely cautious even if the general rate situation remains supportive. Moreover, there is some – though we believe modest – risk that if the renewed trade discussions between the U.S. and China do not bear fruit this could create enough disruption – like the 1978 oil crisis – to trigger a major market decline. But the absence of a bear does not equal a bull and it seems plausible that 2019 will see the continuation of a stock market with lots of volatility, but not much net change.
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The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Refinitiv, or any of its respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.