This market correction reduces the risk of over-tightening
We await more selling pressure given the number of ‘investors’ who were short volatility. The key takeaway from yesterday’s market meltdown is that it reduces the risk that the Fed will over-tighten. It also takes a bit of froth out of an over-extended market.
We shouldn’t be overly concerned yet. But let’s remember the market narrative that preceded the “Hike Havoc”. I have been writing about it for the past several weeks.
If we focus on the economy, then there were already signs in early January that wages were beginning to rise. And data showed consumer credit was rising at the highest rate in 16 years. That’s when the bond bears came out in force. Bond managers Gundlach and Gross added heft to the bearish tilt. Then came the Walmart pay hike. And that added even more fuel to the fire surrounding prospective wage gains — and lurking inflation.
Meanwhile, in the bond market, a narrative of foreign ‘demand’ for US paper built up.The Chinese were net sellers. And deficit spending by Trump would make this worse. The Fed said it was preparing three rate hikes. But the market had yet to move to that view. With the ‘falling demand’ story and the bullish economic data, people started to worry that interest rates were going to go through the roof.
That’s when talk in equity markets began about a potential crash. Jeremy Grantham had already voiced his concerns about a melt-up as the new year began. Then Ray Dalio began to talk about it. Later, US Treasury Secretary Mnuchin made it seem like the Trump Administration wanted a weak dollar. That’s when it crystallized for people: the US economy could really accelerate here. Inflation would take off. And the Fed would mash on the brakes.
That was the narrative — melt-up, followed by meltdown. So now everyone is worried we are already getting an actual meltdown. And people are panicked.
But the economic numbers remain robust. Just last night I wrote about how one can see the vulnerability for a recession in real time. The recession dating committee lays out the criteria that one can judge. For example, in January 2008, the National Bureau of Economic Research wrote that a “recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” That means you have to see weakness in employment, in industrial production, in consumption, in income and in output. We see none of that — just the opposite.
The reason the market is melting down is that the economy is so robust that people have begun to fear overheating. And when bond yields accelerated up, panic set in.
But now Treasury yields have come crashing down as people seek safe assets again. This is an implicit indication that the fourth 2018 Fed rate hike is ‘off the table’, that the risk of over-tightening has receded. That’s a good thing, not a bad thing. It increases the chances that this business cycle will keep on going for some time to come.
I said a lot of this last night, just after the markets closed on CBC’s On the Money with Peter Armstrong. Take a look. My interview is at the top of the show. (link here)
Conclusion: A lot of the narrative behind the bond selloff was wrong. It had nothing to do with demand for Treasuries or deficit spending. It was about the economy and the Fed. At the same time, a host of factors is holding down inflation, while private debt is very sensitive to increases in bond yields; this puts a cap on how high yields can go before they become disruptive. We are seeing this now.
We saw these same kinds of narratives when the Federal Reserve began its large scale asset purchase programs — tales of impending doom and hyperinflation. As a result, a lot of people have got it horribly wrong over the past decade, because it just doesn’t work that way.
I look at the fact that the US government is set to issue $1 trillion of government paper this year as a great experiment — just as QE was. If inflation doesn’t rise in the face of Trump’s huge deficits, we will know if deficits alone will jack up long-term interest rates. So far, that’s not what we’re seeing. What we see is a market that was concerned about overheating and the Fed’s reaction to that overheating in the face of bullish economic news. Now the market is less concerned and the prospective path of future rates is lower. Yet the economy remains on track. That’s good news.