The Market Today
Markets Awake from their Slumber on Fears of Higher Interest Rates
by Craig Dismuke, Dudley Carter
The Fear of Higher Rates on Financial Asset Valuations: One of the primary concerns to economic stability coming into 2018 was the inflated level of asset prices. With economic growth beginning to accelerate beyond what seems sustainable, the risks of inflation and/or more rapidly rising interest rates appeared to be the most acute threats to economic stability – by way of threatening financial asset valuations. This is precisely what has played out over the past week, and more subtly over the past three months. The economic data have been very strong, some of the strongest seen in over ten years. The fear of inflation rose last week after a host of earnings reports showed more traction. Five- and ten-year TIPs-implied inflation expectations rose to their highest levels since 2014. Market expectations for Fed rate hikes rose to their highest projected path of the cycle. And this confluence of factors awoke markets that, in 2017, slumbered through their second least volatile year on record.
Unlikely to Be the Big Turning Point: At some point, the prospects of higher interest rates were bound to trigger a recalibration of equity valuations. However, it is unlikely that rates at current levels are enough to be triggering a full re-calibration. Instead, this is likely just an example of what to expect going forward if the economy continues to manage a better-than-sustainable growth rate, pressuring Fed officials to continue hiking rates.
Not a Reflection of Economic Weakness: At this point, the market actions have not been a reflection of economic weakness. In fact, the ISM report released yesterday was very strong, just like the data of the past week or month. An appropriate fear would be that the drop in equity valuations eventually triggers a significant decline in consumer and business confidence, thereby cutting into economic activity. That seems unlikely after just a few days of renewed volatility, but is the key to watch going forward.
Overnight Activity – Global Equities Pummeled as Yesterday’s U.S. Volatility Carries Over Into Eerie Overnight Session: Yesterday’s historic sell-off in U.S. equities catapulted global stocks deep into negative territory overnight, setting the stage for another nervous day on Wall Street. Hong Kong’s Hang Seng index fell 1,650 points, or 5.12%, as Japan’s Nikkei dropped more than 1,000 points, or 4.40%, and China’s CSI dropped 125 points, or 2.93%. In Europe, every national exchange is weaker, which has the Stoxx Europe 600 down 2.3% but off its early lows. The index tumbled as much as 3.2% on the opening bell. U.S. futures were extremely volatile overnight with the current March contracts on the Dow falling as much as 850 points (an implied drop of more than 1,200 points when adjusted for present value) before recovering to down 336, or 1.4%, at 7:30 a.m. CT. Futures on the S&P are 0.9% lower. For a visual, the ramp up in the risk-off trade has pushed the popular volatility-tracking VIX index above 50 for the first time since July 2015. The global flight out of equity investments has created a bid for European sovereigns as it did yesterday for U.S. Treasurys. The German 10-year yield is down 5.6 bps with the French 10-year yield down an even 5.0 bps. As U.S. equity futures recovered, the intensity in the decline of Treasury yields moderated too and Treasury yields turned positive within the last half hour. After falling to as low as 1.94% overnight, the 2-year yield is up 3.2 bps to 2.0%. A similar swing has the 10-year yield up 4.3 bps to 2.75% after earlier dropping to 2.65%.
Yesterday’s Trading Activity – Markets Wrecked in Historic Day on Wall Street: The February bloodbath that has pillaged equity valuations in the last three sessions stunned market watchers with historic shifts to start the week. The Dow closed down 1,175 points, or 4.6%, but ended 422 points off the lows. That’s no typo. The 1,597 point intraday plunge was the largest single-day point decline in the index’s history. On a percentage basis, it was the largest intraday drop since China’s devaluation of the Yuan in August of 2015 – when the Dow was at 15,871 – and the third largest since 2008. The last two trading days have cut more than 7% from the Dow, the most in a two-day stretch since November 2008. The S&P was also battered, falling 4.1% in its biggest percentage decline since August 2011. The firestorm turned both indices negative for the year and sent each through their respective 50-day moving averages. One notable difference between Monday’s sell-off and last Friday’s drop was the impact on the Treasury market. Last week’s tumble occurred as and because longer yields ripped higher. And while the sell-off is still a ripple effect of both an actual and expected higher interest rate environment, Monday’s equity plunge drove a bid for safety that sent Treasury yields on double-digit declines for most maturities. The 2-year yield fell 11.7 bps to 2.02%, the 5-year yield sank 15.1 bps to 2.44%, and the 10-year yield shed 13.6 bps to 2.70%; all represented the biggest daily drops since Brexit.
ISM Services Index Jumps to Highest Level in Twelve Years: The January ISM Non-Manufacturing index rose to its highest level since 2005. The index, covering almost 90% of economic activity, was expected to tick higher after dropping in recent months. However, it rose much more than expected. The underlying components were almost all strong. The critical new orders sub-index rose from 54.5 to 62.7, the highest level since 2011. And the employment sub-index rose 5.3 points to 61.6, its highest level on record. Combined, the ISM manufacturing and non-manufacturing indices are now consistent with GDP growth of 4.5-5.0%. However, this is only a sentiment index and we do not expect to see such rapid growth.