Ending QE: Another Challenge for Equity Markets

With the Fed ending its POMO operations yesterday (March 9th) following a nearly 5tr USD increase in assets since the beginning of Covid, investors have remained skeptical if the equity market will be able to reach new highs in the medium term. The deterioration in the Russia/Ukraine conflict has left risky assets vulnerable since the start of the year, and the surge in inflation combined with a expected significant deceleration in the economic activity have increased investors’ cautiousness for 2022.

The chart below shows the strong relationship between SP500 and the Fed assets since the beginning of Covid. With the Fed balance sheet pausing at 9tr USD, could we see new all-time highs in US equities in 2022?

Source: Bloomberg

US Inflation vs. Biden’s Approval Rating (Interesting, But Incomplete…)

The chart below (which has been circulating around in recent weeks/months) shows the dynamics of President Biden’s approval rating vs. US CPI inflation in the past year. Even though there have been multiple factors driving the popularity of US Presidents over time, we can agree that the surge in inflation has been one of the major factors behind the sharp fall in Biden’s approval rating in the past twelve months (from 54% in February 2021 to 43% in latest polls).

Source: Bloomberg, fivethirtyeight.com

It is an interesting chart, though it is incomplete. US inflation will remain one of the major themes in markets for 2022 as inflationary pressures are likely to stay elevated longer than what policymakers previously anticipated. Therefore, the Fed will come under tremendous political pressure this year to tighten aggressively to ‘accelerate’ the convergence of inflation back towards its target.

Will Biden’s popularity surge back above the 50% threshold if inflation falls as the Fed tightens?

US politicians must not forget the ‘wealth effect’ factor and the importance of the dynamics of equities in the medium term. An aggressive tightening is likely to weigh on risky assets in the coming year after experiencing a tremendous rally in the past two years following the Covid19 shock. Hence, the impact of inflation Biden’s approval needs to be conditioned on equity market’s performance.

Is it better to have a 7%+ inflation and trending markets or 3% inflation and equities down 25%?

US Dollar seasonality: January is the strongest month

Despite the 13% fall since March, investors’ sentiment on the USD is still extremely negative for 2021. We previously argued that central banks (ex-Fed) will not let the greenback depreciate indefinitely as it will dramatically impact the economic ‘recovery’ (i.e. Euro area is very sensitive to a strong exchange rate) and weigh on long-term inflation expectations. In addition, figure 1 shows that a weaker US Dollar has coincided with a positive momentum in equities in recent years, especially since the February/March panic; therefore, being long US Dollar at current levels could offer investors a hedge against a sudden reversal in risky assets in the short term.

Source: Eikon Reuters

Another interesting observation comes out when we look at the seasonality of the USD in the past 50 years; while December tends to be the worst month on average for the greenback, January has historically been the best performing month with the Dollar averaging nearly 1% in monthly returns since January 1971.

Is it time for a ST bull retracement on the US Dollar?

Source: Eikon Reuters, RR calculations

Jobless claims and non-farm payrolls

Two popular indicators that investors frequently watch to measure the temperature of the labor market in the US are the jobless claims and the non-farm payrolls. Historically, the market has been focusing more on the monthly NFP prints, but the recent waves of selloffs due to the Covid-19 crisis has raised investors’ interest on the weekly jobless claims figures as the number of Americans filing for unemployment benefits has surged to over 6 million in the past two weeks.

In this post, we try to answer the following two questions that have been making the headlines in recent weeks:

  • Is there a link between jobless claims and non-farm payrolls?
  • As jobless claims are updated every week, does it lead NFP?

 

Jobless claims are a statistic that is reported every week by the US Department of Labor and counts the number of people filing to receive unemployment insurance benefits. There are two categories: initial – with people filing for the first time – and continued, which comprises of unemployed people who have been receiving unemployment benefits for a while. What is surprising this time is the recent rate of change of the initial jobless claims, which surged from multi decades lows of 200+ thousands to over 3.3mil, 6.8mil and then 6.6mil on April 4th. Prior Covid-19, initial jobless claims have generally averaged 360K since the 1960s, from lows of 200K to highs of 700K (figure 1, right frame). The number of continued jobless claims is now greater than the one experienced during the Great Financial Crisis, which reached a peak of 6.6 million in June 2009.

Figure 1

FI1

Source: Eikon Reuters

Non-farm payrolls are also released by the Department of Labor on a monthly basis as part of a comprehensive report on the state of the labor market, but do not include farm workers, private household employees or non-profit organization. It was reported that the US lost 701K jobs in March, which brought the unemployment rate to 4.4%. Figure 2 (left frame) shows a scatter plot of the continued jobless claims with the NFP monthly; we are currently sitting at uncharted territories, and we would expect the next prints of NFP to collapse to much lower levels in the coming months, which would raise the unemployment rate to more than 20 percent. According to the fitted line, a 701K drop in NFP would coincide with continued jobless claims of 4.5 to 5 million.

In figure 2 (right frame), we look at the yearly gains (losses) in NFP overlaid with the continued jobless claims times series. We can notice that to the exception of the Great Financial Crisis, the amount of people filing for unemployment benefits has always been greater than the number of jobs lost in the US economy. This is what we expected as the NFP do not include a little portion of US employees. If you add the number of jobs lost in the agricultural industry in addition to the local government, private household and non-profit employees, you will certainly reconcile the two figures (i.e. number of total jobs lost = continued jobless claims).

Figure 2

FI2

Source: Eikon Reuters

It is difficult to infer a level of unemployment rate from the jobless claims data, but we just know that the level will be elevated in the coming months. Some economists have forecasted a 10% unemployment this summer, but we think it could actually reach 20 percent as the uncertainty around employees’ status will surge to historical highs. US households will start to save more as most of the companies are now very vulnerable to the demand shock, which would in theory be deflationary (at first).

Even though the chart is far from being perfect (figure 3), we like to look at the 3-year returns in stocks (in order to smoothen the volatility in equities) as a leading 1-year leading indicator of unemployment. Sharp and sustain selloffs in equities are usually associated with rising unemployment as equities’ valuations directly reflect the level of consumer sentiment in the market.

Figure 3

FI3

Source: Eikon Reuters

Great Chart: US Yield Curves: 5Y30Y vs. 3M10Y

On Friday (March 22nd), the disappointing German PMIs led to little sell-off in global equities and a rise in risk-off assets such as government bonds and safe-haven currencies (i.e. JPY, CHF). For the past month, we have been warning that the elevated uncertainty in addition to the low level of global yields were challenging the healthiness of the equity recovery since the beginning of the year. Moreover, fundamentals have been fairly weak overall (in the US, China and even in the Euro area), with leading economic indicators diverging from equities’ performance. For instance, many indicators have been pricing in a slowdown in the US economic activity, however the SP500 index is up approximately 14 percent year-to-date and trading 100pts short from its all-time highs reached in the end of September last year.

With the German 10Y yield falling in the negative territory, the amount of debt trading below 0 percent reached $10tr, up $2tr since the beginning of the year. In addition, the divergence between the 3M10Y and 5Y30Y yield curved have continued; while the 3M10Y turned negative (gaining all the market’s attention), the 5Y30Y has been trending higher in recent months, up 40bps to 66bps in the past 6 months. In this great chart, we can notice an interesting observation: each time the 5Y30Y has started to steepen before the end of the economic cycle, the 3M10Y followed the move 6 months later. We know that the critical moment of the business cycle is when the yield curve is starting to steepen dramatically. Hence, should we worry about the steepening of the 5Y30Y?

Chart. 3M10Y vs. 5Y30Y (6M Lead) – Source: Eikon Reuters

US yield

Great Chart: US Term Premium vs. Business Cycles

Academics and economists have often decomposed the long-term bond yield of a specific country (i.e. US 10Y Treasury) into the sum of the expected path of real interest rate (r*) and the additional term premium, which compensate investors for holding interest rate risk. Two major risks that a bond investor typically face in the long-run are the change in supply of and demand for bonds and the uncertainty around inflation expectations. If the uncertainty increases, the market will demand a higher premium as a response. As the premium is not directly observable, it must be estimated using econometric models. For instance, a popular one that practitioners use is the one developed by Adrian, Crump and Moench (2013), who estimated fitted yields and the expected average short-term interest rates for different maturities (1 to 10 years, see data here).

As you can see, the term premium has been falling since 2009 and is currently negative at -51bps, which has not happened very often. Instead of having a positive term premium for long-term US debt holders carrying interest rate risk, there is actually a discount. The term premium for the 10Y reached an all-time low of -84bps in July 2016, at the same time that the yield on the Treasury reached a record low below 1.40%. However, there are also interest findings when we plot the ACM 10Y term premium with macroeconomic variables. If we overlay it with the US unemployment rate, we can notice a significant co-movement between the two times series. The jobless rate went down from 10% in Q3 2009 to 4.1% in March 2018, tracked by the term premium that fall from roughly 2.5% to -50bps in that same period. In other, it seems that the term premium follows the business cycles, trend lower in periods of positive growth and falling unemployment and rises in periods of contractions. Therefore, for those who are expecting a rise in the US LT yields in the medium term, driven by a reversion in the term premium, what does it mean for the unemployment rate going forward?

Chart. US Unemployment Rate vs. 10Y Term Premium

US Term Pr.png

Source: Reuters Eikon and Adrian et al. (2013)

 

Great Chart: Term Spread Differentials (US, Germany and Japan)

In this article, we define the term spread of a specific country by the difference between the long-term (10Y) and the short-term (2Y) sovereign yield, which is also referred as the yield curve. As we mentioned it in one of our previous Great Chart articles (here), empirical research has shown a significant relationship between the real economic activity of a country and the yield curve. In today’s edition, we chose to look at the historical developments of the term spread differentials, between the US and Germany and the US and Japan.

Over time, we notice that the term spread has some interesting co-movement with the exchange rate. For instance, between 2005 and 2017, a widening term spread differential between the US and Germany was favourable to the USD/EUR exchange rate (here), meaning that the Euro was appreciating when the US yield curve was steepening more significantly than the German one. However, we saw that the relationship between the two times series broke down in early 2017 and has actually reversed over the past 14 months (here). In other words, based on the current market levels, the 2Y10Y term premium in Germany offers 56bps more than the US. Hence, as the term structure in the US has flattened strongly relative to Germany (yield curve steepened from 50bps in July 2016 to 118bps), the US Dollar depreciated.

This chart shows the evolution of the term spread differentials – between US and Germany and between US and Japan – since 1985. We can observe a strong correlation between the two times series over the past 30 years, with the term spread differential against Germany trading at -57bps, its lowest level since June 2006, and at 42bps against Japan, its lowest level since June 2008, respectively. An interesting observation comes out when we look at the spread between the two TS differentials (US-Japan vs. US-DE), which simply comes back at looking at the cross term spread differential between Germany and Japan. At the exception of the year 1992, the DE-Japan TS differential has always traded between -1% and +1%, and is currently standing at the high of its long-term range. The TS differential currently trades at +1% on the back of a steepening German yield curve since the summer of 2016 (2Y10Y moved from 52bps in July 2016 to 119bps today). It it a good time to play the convergence between the two term structure, i.e going long the German 2Y10Y term spread and short Japan 2Y10Y? The risk of the trade is on Japan side, as shorting the 2Y10Y would imply a steepening yield curve with either the 2Y yield going down or the 10Y rising. With the current BoJ ‘yield curve control’ (YCC) policy, we know that a steepening yield curve in Japan is difficult for the time being, but it will be interesting to see where TS differentials stand in a couple of months.

Chart: Term spread Differentials – Japan and Germany vs. US (Source: Reuters Eikon)

Term Spreads ALl

Great Chart: Gold vs. US 5Y Real Yield

We showed in many of our charts that 2017 was the year where some of the strong correlations between assets classes broke down. We showed USDJPY vs. TOPIX (here, here), Cable (here) and EURUSD (here) vs. the 2Y and 10Y interest rate differentials, and this week we chose to overlay Gold prices with 5Y US real interest rates. As we explained it in our study on Gold (here), the relationship between Gold and US [real] rates is easy to understand. The precious metal is a non interest-bearing asset, meaning that a typical investor doesn’t get any cash-flow from owning it (unlike dividends for stocks and coupons for bonds), and has usually a storage cost associated with it. Therefore, the forward curve of the ‘currency of the last resort’ (Jeffrey Currie) is usually upward sloping, in other words Gold market is in contango, with the forward price equal to the following:

Reg.PNG

Hence, if real interest rates start to rise, a rational investor would prefer to reallocate his wealth to either US Treasuries or Treasury Inflation Protected Securities (TIPS) and receive coupons rather than keeping a long position in a commodity that has a ‘negative carry’.

As you can see it on the chart, Gold prices (in US Dollars) and the 5Y TIPS real yield have shown some strong co-movements over the past 5 years, until the summer of 2017 when the two times series diverged. If we would follow recent moves on the market, the late surge in Gold prices (currently trading at 1,340 $/ounce) would imply a 50 to 60 bps decrease in US real interest rates (note that if we regress the change in Gold prices on the change in the 5Y real yield using weekly data since 2013, we find that a 1% increase in real yields lead to an 8.7% depreciation in Gold prices). And lower real rates would either come from higher inflation expectations or lower nominal interest rates. With the 5Y5Y forward inflation swap currently trading at 2.11% and up 30bps over the past 6 months, core inflation and core PCE YoY rates at 1.8% and 1.5% slightly moving to the upside, and oil prices still trending higher with WTI front month contract trading at $64.5, there is room for higher inflation prints coming ahead. However, if the two curves were to converge in the short term, the [sharp] move would come from either [lower] Gold prices or [lower] Treasury rates.

Our view is that the divergence will persist in the beginning of 2018, with inflation remaining steady / slightly increasing and US interest rates failing to break new highs on the long end of the curve (5Y and 10Y). The main reason for that is that we think market’s confidence on the Fed’s 4 or plus hikes will slow down in the coming months on the back of lower-than expected fundamental, depriving the yield curve from steepening too much.

Chart: Gold prices vs. US 5Y TIPS (inv.) (Source: Reuters Eikon) 

WeeklyGold.PNG

 

Great Chart: SP500 vs. US 2Y10Y Yield Curve

Historically, research has shown that the difference between long-term and short-term interest rates (‘Yield Curve’ or ‘Time Spread’) has shown some significant negative relationship with subsequent real economic activity in the United States, with a lead of about four to six quarters. Hence, with the current low levels of the US yield curves (2Y10Y or 5Y30Y), we chose today this week to overlay the 2Y10Y yield curve with the SP500.

If we say that low yield curves tend to predict recessions, then the question now relies on quantifying a low level of the yield curve. We hear from many analysts that the current levels are very low, however if we look back at 40 years of data, the US yield curve levels are not that far away from their long-term averages. For instance, the 2Y10Y and 5Y30Y slopes are currently trading at 51bps and 53bps, while their LT averages stand at 95bps and 82bps, respectively (see here). One main reason why yield curves have been crashing over the past few months is mainly due to an increase in the front-end of the US curve on a back of a shift in expectations of monetary policy. The US 2Y interest rate is now trading at 1.96%, its highest level since September 2008. On the other hand, the 10Y yield stands at 2.46%, has been ranging between 2% and 2.6% over the past year and is up 110bps from its historical low of 1.36% reached in July 2016.

The chart below shows the importance that even if the yield curve turns negative in the US, the equity market has still upside potential in the following months. In our first observation, the 2Y10Y time spread went negative in February 2000, while the SP500 continued its rally and reached a peak in September the same year. In the second one, the yield curve inverted in June 2006 (if we ignore the Jan-Mar 2006 episode) while equities continued to rise for more than a year, peaked in October 2007, and the US plunged into the Great Depression in December 2007.

We don’t think that the current levels of the yield curves are actually alarming for the US economy and we may see a potential floor in the first quarter of this year as we believe that market participants’ (over)excitement on the Fed potential hikes will ease in the medium term. The probability of 4 or more hikes has soared to 12.1%, which pushed the front end of the US curve on the upside and explains the sharp flattening we saw in 2017 (from 1.27% to 0.5%). However, if we look at the EuroDollar futures market, the December 2018 contract currently trades at 97.81, suggesting that investors are pricing in a ST interest rate of 2.19% by the end of the year (see here). This analysis also confirms our bearish view on the US Dollar for 2018 (especially against the Euro).

Chart: SP500 (yellow, rhs) vs. US 2Y10Y Yield Curve (Source: Reuters Eikon)

Yield Curve.PNG

Rising US corporate default rates during a tightening monetary policy cycle

In this study, we mainly focus on the refinancing issues that US [non-financial] companies will face within the next five years as a lot of corporations are trading at a distressed price (or yield) due to the lack of global growth and low commodity prices. In the first session, we review the US credit market structure. Then, the second session introduces a two-state Markov switching model (Hamilton, 1989), followed by a presentation of the paper Corporate bond default risk: a 150-year perspective (Giesecke & al., 2011), a study that uses a set of macroeconomic and financial variables to forecast default rates in the US. In the third Section, we comment the potential change in the explanatory variables since 2009 and we discuss a solution to avoid a new clustered default event over the next five years.

Link ==> Studies on Corporate Defaults