There are a lot of probably reasons for the recent stock market volatility. Here are a few. Investors have become too complacent; valuations are stretched, and all the good news is already in prices. It doesn’t take too big of a bump in the road to knock a few apples off of the top of cart. That bump in the road came in the form of a slight increase in longer-term interest rates which unwound some leveraged positions and trading strategies which subsequently spiked measures of volatility, which led to more trade unwinds.
In the author’s view, understanding how sensitive stocks and the economy are to a rise in interest rates is the key to forming a view on where markets are headed in 2018 and 2019.
For example, housing plays a huge role in our economy. Not only does housing create industry and economic activity, including everything from building materials to furniture, home prices drive geographic mobility, job turnover rates, consumer confidence and spending, and are even correlated with birthrates. With measures of home affordability already moving towards concerning levels, the recent modest rise in mortgage rates is registering a significant negative impact on home sales.
Over the last several years the US Federal reserve and other global central banks have gone to “extraordinary” efforts to manipulate, push, and hold interest rates low. Their actions include setting short-term interest rates near or below zero and pushing longer-term interest rates to historical lows through quantitative easing, the Federal Reserve’s strategy of buying huge sums of benchmark bonds whose yields are the basis for interest rates on everything from mortgages to business loans.
The US stock markets has clearly benefited from Federal Reserve policy. It is a fact that stock market performance over the last several years has been correlated with the size of the US Federal Reserve’s balance sheet and policy announcements.
Federal Reserve policy helped to create the low volatility environment during which market participants came to believe in the Greenspan, Bernanke, and Yellen “put;” a belief that if and when anything negative were to happen that the Federal Reserve would step-in to support and calm markets.
While it is yet to be seen if the “put” still exists under the new Federal Reserve Chairman, Jerome Powell, the signaled unwind of low short-term interest rates and the scheduled unwind of quantitative easing is already well under way.
Is it not reasonable to expect that after several years of “extraordinary” Federal Reserve policy which had a very positive impact on markets that there will be some measure of an opposite impact as that policy is reversed?
With the recent market volatility there has been a lot of discussion and research on exactly what level of interest rates might trigger further stock market declines. Some analysts show no signs of concern; others peg that level at somewhere between 2.75% and 3.0% as measured by the yield on US 10 year Treasury bonds, the most widely watch benchmark interest rate in the world.
The author suggests that if you want to stay ahead of the curve that you watch two important indicators.
First, watch the Federal Funds rate, as set by the Federal Reserve, in relationship to 10 year Treasury bond yields. This is known as the yield curve. A flatter yield curve is indicative of slowing economic activity. An inverted yield curve is a sure sign of economic recession. The Federal Reserve is currently signaling as many 4 increases to the Federal Funds rate in 2018. Watch to see if 10 year Treasury bond yields increase by an equal or greater amount. The yield curve has been flattening over the last year. Beware of an even flatter yield curve. Information and analysis on the yield curve is easily found online.
Second, watch to see how stocks perform in relationship to 10 year Treasury bond yields. 10 year Treasury bond yields don’t seem to be able to move much higher than 2.9% because when they do stocks fall which in turn pushes money into bonds which in turn keeps the yield from moving higher. It is a very interesting and significant relationship. If is easy to chart both 10 year Treasury bond yields and stocks online.