Wednesday, October 10, 2018

Just another panic attack

The S&P 500 has lost about 5% since last month's record high, but it's still up about 4% year to date. It's painful, but still short of a typical correction (-10%). The culprit? News reports cite the 80 bps rise in 10-yr bond yields this year, Fed tightening, rising tariffs, and the flatter yield curve. 

I don't buy most of that. Bond yields are still unusually low, and the driver of higher yields is rising real yields, which reflect a stronger economy; why should a stronger economy be bad for stocks? The Fed hasn't even begun to tighten, since the real Fed funds rate is only slightly above zero; short-term borrowing costs are almost free. The yield curve has flattened, but it is still positively sloped; the all-important real yield curve is still nicely positive—no implied threat there. Rising tariffs are a genuine problem, to be sure, but that's still in the nature of a headwind rather than impending doom. Tariffs can be dismantled as fast as they are applied, and Trump has made good—if hardly perfect—progress bringing down tariffs with Canada, Mexico, and the Eurozone. China is the main problem, and it boils down to a big game of tariff chicken. It's in no one's interest to escalate this conflict to outright tariff wars. I remain confident that the future of global trade will be "freer and fairer." The truth about tariffs is that a) they mainly hurt the country that applies them, and b) lower tariffs are always better for all concerned. I'm not ready to bet that Trump and China will refuse to come to an agreement that would be mutually beneficial.

Right now, my best guess is that this is just another panic attack, of which we've had quite a few in recent years. They've all been resolved eventually, as the stock market manages to climb successive walls of worry. This is healthy. It wouldn't be surprising to see prices decline further, but it would be surprising if this proved to be the beginning of a major rout or recession.

Here are some up-to-date charts that focus on key indicators:

Chart #1

The Vix index is the classic measure of investor's fears; the higher it is the more it costs to buy the protection of options. I like to divide it by the 10-yr Treasury yield, since that is a proxy for the market's growth expectations; the higher the yield, the stronger the economy, and vice versa. The ratio of the two is thus a measure of how fearful and doubtful the market is about the future. It jumped today, but as Chart #1 shows, it is a minor blip from an historical perspective. Note how jumps in the Vix/10-yr ratio always coincide with big drops in equity prices.

Chart #2

Chart #2 shows 2-yr swap spreads in the US and Eurozone. Swap spreads are an absolutely key measure of market liquidity and systemic risk (the lower the better). Swap spreads also have proven to be excellent leading and coincident indicators of financial market and economic health. Conditions in the Eurozone aren't quite as good as they are here, but conditions in the US are about as good as they get. There is plenty of liquidity, which is essential to ensure orderly markets. With plentiful liquidity, the market can price in and deal with all sorts of problems. Problems arise when liquidity is scarce and markets are thus unable to perform one of their key functions, which is to distribute risk from those who don't want it to those who do. This chart is also prima facie evidence that the Fed is NOT tightening monetary policy.

Chart #3

Chart #3 compares the prices of gold and 5-yr TIPS (using the inverse of their real yield as a proxy for their price). It's remarkable that the prices of these two distinct assets should tend to move together. Both have been in a gentle downtrend for the past several years. I've interpreted that to mean that market is gradually losing the risk aversion that peaked about six years ago. Confidence is replacing risk aversion, and with rising confidence comes less demand for the safety of gold and TIPS. This is healthy.

Chart #4

Chart #4 shows a popular measure of the dollar's value against other major currencies. By this measure, the dollar has been roughly flat for almost four years. Problems usually arise when the dollar experiences big moves up or down, since that can and often does reflect big changes in monetary policy (tight money tends to strengthen the dollar, and vice versa). This is a good indicator that US monetary policy is not causing significant problems for the rest of the world.

Chart #5

Chart #5 shows the real and nominal yield on 5-yr Treasuries (blue and red lines) and the difference between the two (green line), which is the market's average expected rate of inflation over the next 5 years. Note that inflation expectations have been relatively stable around 2% for quite some time, and especially over the past several months. This means that nominal and real yields are rising and falling by about the same amount, which further means that what is driving the ups and downs in interest rates is changes in real yields. As I've noted many times before, real yields have a strong tendency to follow the real growth trend of the economy. Real and nominal yields are up because the bond market is becoming more optimistic about the health of the economy. Nothing at all wrong with that!

Chart #6

Chart #6 compares the real yield on 5-yr TIPS (inflation-protected securities) with the real Fed funds rate, which I calculate by subtracting the year over year change in the core PCE deflator from the nominal Fed funds rate. The real funds rate is the best measure of how "tight" or "easy" monetary policy is. What this chart shows us is that over the past few years the Fed has moved from being very accommodative to now roughly neutral. This is not threatening, especially considering the improving health of the economy. In truth, what would be very worrisome would be if the Fed had NOT raised rates, since that would have given us a weaker dollar and rising inflation. 

Chart #7

Chart #7 shows the evolution of the slope of the Treasury yield curve between 2 (orange) and 10 (white) years. Nominal yields are on the top portion of the chart, while the difference between the two (the slope of the curve) is shown on the bottom portion. Note that the curve has been steepening for the past two months. This is prima facie evidence that the Fed is NOT too tight. Instead, it tells us that the market is expecting the Fed to continue raising short term rates modestly. If the Fed were too tight, the curve would be inverted, and that would mean the market was expecting the Fed to have to cut rates. There's nothing scary about the current shape or slope of the yield curve.

Chart #8

Chart #8 shows Credit Default Swap Spreads for investment grade and high-yield corporate debt. These are highly liquid and reliable indicators of how concerned the market is about future corporate profits (the lower the better). While spreads have increased a bit of late, this is a mere blip from an historical perspective. Credit spreads are still relatively low, which is another sign that the market is not very worried about the health of the economy.

We likely will learn more about what sparked the current panic attack in the fullness of time. But for now, it looks to me like it's just another one of those unpredictable—and disconcerting—reversals that occur from time to time. Market are like that. Things should get back on track eventually, because there is no sign as of now of any serious deterioration in the market or economic fundamentals. 


George Madison said...
This comment has been removed by the author.
Scott Grannis said...

Re: “China is not going to give that up until they are feeling serious pain.”

That’s a good point, but I would add that China is not exactly pain-free these days. The currency has taken a serious hit of late, and forex reserves are down as well. The Chinese stock market has been trending down for many months, and it has seriously underperformed the US market. The central bank recently had to ease reserves requirements (again) in order to prop up the market. These are market-based signs that conditions in China are deteriorating. Capital is leaving the country. Anecdotally, I’ve seen news reports that point to spreading dissatisfaction with China’s president-for-life, and his failure to negotiate with Trump. China is becoming isolated and it’s under pressure.

Meanwhile, the US economy is picking up momentum, the US stock market is one of the strongest in the world, and Trump’s policies are producing positive results. Trump is in a strong negotiating position.

Benjamin Cole said...

Another superb wrapup, and Scott Grannis has convinced me.

Now, if someone will just convince my gut.

steve said...

I completely disagree with your analysis re China. IF China was a normal good ol capitalist nation-sure. But, they're not. They don't give a hoot about their citizens and they have more intransigence than the US can have because they don't have ELECTIONS. DT picked on the wrong puppy and this will (is) get seriously messy.

marcusbalbus said...

pangloss: set aside your vanity for a few weeks. people believe you are an investment advisor; you are not. you are a middling economist obsessed with charts and optimism.

do no harm.

steve said...

Marcus, you're an ass.

Be that as it may, this is concerning:

Yes, I know all about Japan and they're managing of their debt but do we really want to mimic Japan? As I've said repeatedly, it's hard for me to believe that we're going to get through four years of DT without something really bad happening. He and his trade team are just-well, STUPID.

marcusbalbus said...

steve: do you drink beer?

Grechster said...

Re: the prior discussion of debt and deficits... I would encourage all to watch the CNBC interview with Jeffrey Gundlach that just occurred about 1 pm est today.

Adam said...

Thanks for your post Scott.
One of the reasons behind current correction is simply - investors positioning. US market was historically higly owned according to last data. Once a month BOFA releases given report. It is "available" via that blog:
Not a cristall ball, but helpfull.

steve said...

Matthew, an interesting and scary piece. ADD to that the fact that the dolt DT and his minions is pissing off China big time and therefore they're not going to be buying treasuries. In fact I would not be at all surprised if the selloff is largely related to this realization.

randy said...

The wildcard does seem to be how China will play out. So far, no one expected Trump to go this far with it. So, so far all the pundits have been wrong. Some in the administration are approaching this from a long-term national security and power perspective. The view may be a significant but survivable downturn would be a worthy price to pay for crippling China. I was going to call them crazies, but Realpolitik is a rational option for an adversary that doesn't play by the same rules. I'd still like to think there are less risky paths.

marcusbalbus said...

pangloss: take down this post. do none harm.

Johnny Bee Dawg said...

If DEMs gain power next month and derail MAGA, you'll understand why stocks just sold off.

Kman said...

The thing with china is a lot more than trade. I'm not sure if DT himself realises that, or maybe he does, but cant quite explicitly say so. India will be next. 1,4 and 1,3 bill population respectiviley with great tech and engineering talent, a developing market as well as manufacturing powerhouses. Should be interesting.

steve said...

JBD, I'd be shocked if the dems take the house and forget about the senate. The middle third will decide this election and I have a hard time believing that they will en masse vote against their pocket book.

Of course AFTER that all bets are off. Unlike Scott, I believe DT and his minions are intractable on trade with China and as I've pointed out China can wait...

E cigarette aficionado said...

The economy very well maybe ok (for now) but at the same time the market maybe going much lower due to valuation.

Valuation became someone meaningless in a super low rate interest environment and I believe we are seeing the beginning of a market re rating that will affect nearly all stocks as bonds become more attractive.

Al said...

All in the spreads. They are nice!

Benjamin Cole said...

Scott Grannis: what is the source for chart #8 on spreads?

As always, great charts....

Johnny Bee Dawg said...

Fed comments about wanting to raise rates "above equilibrium" are troubling. Trump's tariffs are 100% designed to inflict pain to make China capitulate. They aren't economic policy other than to reign in the bad actors, no matter how much pundits assume otherwise.
If the Fed is trying to undermine our position of strength, the China negotiations wont go as well.
Markets get it.
Swamp dont wanna be drained.
China is trying to affect an election, and all of Washington, DC is in China's pocket. So, no investigations forthcoming. get it. Markets hate anything that undermines MAGA.

steve said...

JBD, There is NO WAY to figure out what makes the markets move short term You sound like one of these TV idiots who suggest they know what moved the markets TODAY. Gimme a break...

In the meantime:

xr-3609 said...

I agree with George Madison, Trump's stated and actual struggle with China is strategic, with implications for global power dominance decades in the future. There are questions:

1. If Trump caves before success; it will have effectively become, in hindsight, a game of "tariff chicken"
2. China is experiencing a debt and real estate bubble, along with a slowing economy, will the US tariff conflict push it into a recession?
4. What would a Chinese recession cost the US in terms of GDP?

Johnny Bee Dawg said...

I wonder if anybody could think of a reason that stocks took off like a jack rabbit back in November 2016.
Its all so unknowable!!
There's NO WAY to know!!!

Fred said...

I thought Marcus ordered Scott to take this post down. Why is it still up?

marcusbalbus said...

so we can all admire JBD's "worse than leprosy" visage, the peanut gallery's gullibility, and of course pangloss's vanity.

Fred said...

All excellent reasons. Thank you.

Unknown said...

Thanks Scott, great write up. You should be the ringleader on WTWA !

George Madison said...
This comment has been removed by the author.
The Gunny said...

Mr. Grannis,

I appreciate the depth of knowledge from which you share your opinions. I was first introduced to your blog by a representative of Western Asset. As a practicing financial advisor, I find a few sources with the intellectual pedigree that you possess which makes me comfortable enough to share with clients. May I have your permission to share links to your blog with clients?

Fred said...

Weren't these charts showing that the economy was healthy in late 2007? Also, didn't you say during the Obama administration that debt levels were too high? What happens to that debt service as interest rates continue to rise? It seems as though it might pay to be a bit more cautious.

Scott Grannis said...

Re "Weren't these charts showing that the economy was healthy in late 2007?"

Some charts could be interpreted as "healthy" in late 2007. But quite a few very key charts could not. For example, in late 2007 2-yr swap spreads were rising, real yields on 5-yr TIPS were double what they are now, the Treasury yield curve was flat/inverted, credit spreads were high and rising, housing starts were plunging, and consumer confidence was falling.

Scott Grannis said...

Re "May I have your permission to share links to your blog with clients?"

Of course.

Fred said...

I heard Alan Greenspan interviewed on the radio this morning, and he seems very worried that entitlements are a major threat to the economy. While he would ordinarily be happy about the tax cuts, he said the problem is that we have not cut spending. It seems hard to believe that we can go on for long this way without a huge impact on the markets.

xr-3609 said...

Scott: Thanks again for a truly informative blog!

As for marcus: "Let the doors be shut upon him that he may

play the fool nowhere but in's own house.


Scott Grannis said...

Re: entitlements. They are indeed a big problem. Something must be done to cut them back/slow their growth. Fortunately, it's not impossible, but it does require political backbone which is still in short supply. Meanwhile, growing the economy is the next best solution, and that is proceeding.

A glimmer of good news on the spending front: total government spending in the recently concluded fiscal year was $4.108 trillion, and that was only 3.2% more than the $3.981 trillion of the prior fiscal year. Spending is shrinking relative to GDP, and that is welcome news.

marcusbalbus said...
This comment has been removed by the author.
marcusbalbus said...

xr-3609: are you HAL 9000 salvaged from the Hollywood prop junk heap? Are you feeling better now? Does Dave still love you?

CBP is vain. He should do none harm. He is not an investment advisor. Take down the post. Even HAL and JBD should be protected from your incompetence.

Fred said...

I suggest pistols at 10 paces as the only way to settle this once and for all.

Johnny Bee Dawg said...

Steve....still clueless about why markets cracked?
Still NO WAY to know?

Fred said...

I think you are right about the FED JBD but is it really likely that they will raise rates above equilibrium? Also, it seems very unlikely that even a blue wave will produce veto proof democratic majorities in Congress. Taxes will not go up and neither will regulations increase prior to 2020. Seems like FANGS have been a huge driver in the run up and perhaps were overvalued?

steve said...

JBD, y point re why markets are moving is that to suggest as the pundits on CNBC do that the markets are moving for one reason or another is to imply that you can "time" the markets which is fatuous at face value.

The markets move for one reason; more buyers than sellers or vice versa. Why more? No one knows. Sure as hell not you.

Johnny Bee Dawg said...

There's no reason for the Fed to actually raise above equilibrium, Fred, unless they want to cause damage to the current progress. Nothing justifies it in the data.
Their words were enough to crack markets a month before midterms. Sly dogs. They dont have to follow thru with actions.

"Immoral suasion" works well enough to give MAGA a kick in the balls, make tariffs matter, and harm Trump's negotiating stance with China.
Half the S&P stocks (246) are already down 20% or more, now, so mission accomplished™, right before election!
That will be over soon enough.

Reminds me of Yellin's ham-handed FOMC execution on the last day of January when she dropped off the keys and trashed the place on the way out the door. She didn't even care about losing the deposit. Fastest 10% decline from all-time highs in market history. POW! Take that, MAGA voters!
Happened to coincide with the House Intel Committee report on FBI and DOJ corruption, but that was a coincidence.
Swamp don't wanna be drained.
Markets get it.

If America were to actually vote in some huge Blue Wave (picking Mobs over Jobs), then we have bigger problems than any of us have imagined. Surely not.
I can't believe such a thing actually occurs. Got more faith in We The People than that. But we shall see.

But there's just NO WAY to know why markets declined after harsh FedSpeak right before elections!! NO WAY!!!!

Just like there was NO WAY to know why futures reversed up almost 1000 points instantly after Barney Frank announced the mark-to-market accounting changes would be undone. Or why the bank index rallied 20% after every rumor of him doing so.
Just like there was NO WAY to know why markets took off like a jack rabbit when Trump was elected.
There's NO WAY to pay attention to markets and see how they react to favorable policy...or unfavorable.

Its all such a quandary, steve!! Wrapped inside an enigma. Mysterious.

Unknown said...

Is everything ok old buddy? We haven't heard from you in a while!

Adam said...

On FED QE undo, here is the impact calculated, if one believes in that theory.

Comanche Pilot said...
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Comanche Pilot said...

Don't give up Scott; or let the trolls get you down. Many, many of us appreciate your insights and do not take them to be guarantees or recommendations, rather observations that we can use in whatever way we choose. Those that throw excrement in your direction should just be ignored. Have a great Thanksgiving today, and thank you.