What Happens When You Get Too Tight
How to SHIFT a Hike Hangover
After the previous week’s US rate hike inspired turmoil, this week saw the market wait nervously with bated if not punch drunk breath, for the minutes of the FOMC rate hike meeting. They sought greater clarity about the US monetary policy and global market direction particularly with respect to FANGs and the allegedly yield sensitive NDX but got little. As a result this weekend has again produced a number of stock and Dollar collapse comparisons particularly after Friday’s thirtieth anniversary of the Black Monday crash on October 19 1987 with a particular focus on Monday itself (tomorrow). You could be forgiven for thinking, as the eight year major proponent of this template, that we would be at the front of the queue. After all we sold the top of Friday’s rally aggressively in DAX, SPX, DJIA and NASDAQ and are long EURUSD. But possibly not for as long as many would think. Indeed we spent much of late Friday picking bottoms to reduce that risk into the Option expiry and the weekend.
The market is following a strategically important period. History (and particularly the historical interaction of FITS -Fundamental, Intermarket, Technical and Sentiment) shows this is an extremely volatile market that presents opportunities both ways rather than one.
As we pointed out last week the technical similarity is now much closer to 1929 in the last correction. One of the crucial ironic (and sentiment) differences between now and 1987 is that traders were not focused on any crash anniversary. The fact some if not many are looking for it is an argument against. The history of SPX price action around October 19th since 1987 provides a clear prognosis: two way volatility.
But more importantly, the market is experiencing very similar price action to the last tightening phase – the end of Quantitative Easing. Markets tend to react a certain way through rates hike and tightening and not necessarily into a crash.
In this week’s we seek to explode the age old myth that stock markets particularly NDX always maintain an inverse relationship to yields, and explore an interesting fractal that show why the market reaction to the end of Quantitative Easing could be instructive. NDX is clearly following the same cycle from 2008-2014 that saw the introduction and end of QE.
The similarities between 2014 and 2018 are stunning.
The timing of each rally and correction, especially the October correction is partly down to seasonality, but mostly because of the conditions. The markets are experiencing an effectively similar tightening cycle we saw into and beyond the end of Quantitative Easing. 2014 was the year the QE tapering ramped up and eventually brought an end to the bond buying program.
In comparison, 2018 is not only a year of multiple rate hikes, but also the year the Fed’s QT (quantative tightening) is ramping up, and from October onwards the full $50bn of bonds being are retired at maturity.
Yet as the 2014 and 2018 NDX comparison shows, the market can still trend higher under this backdrop of tightening. It may to lead to a slower gradient, with some sharp corrections when the Fed is deemed overly tight, but are these corrections driven by fundamentals, or just a shift in sentiment when the market is overly long and the Fed sends the “wrong message”?
The October 2014 correction followed the September Fed meeting where QE was not only tapered, but the Fed indicated it would end completely at the end of the year. As prices declined, the end of QE seemed more and more like a big deal.
Yet as we now know, the market snapped back into the year-end just as fast as it fell. And as we can see, the reaction to tightening is fairly consistent.
These reactions lead us to question the common belief that rising yields are bad for equities. This may be the case for bond-like dividend stocks and sectors such as utilities (XLU) and REITS (XLRE), or stocks with high debt, but many growth stocks in the Nasdaq actually have a positive correlation, as we can see by comparing Amazon (AMZN) to the US 2yr yield (in red).
The broader market correlation has also been generally positive over the longer-term.
This is after all, a logical relationship. When yields are rising for healthy reasons—economic strength and growth—many stocks, especially growth stocks, rise too. Yet this relation has many caveats; the correlation was negative in 2014 and risks flipping negative again in 2018 (note it is approaching zero on the above chart). One reason for this is if yields rise too rapidly, they risk spooking the market irrespective of what is driving the rise. This is what we saw happen in January, and again in October, and is was described by Goldman Sachs earlier this year
“S&P 500 returns have typically been negative in months where bond yields have risen by more than 2 standard deviations. When bond yields have surged by 1-2 standard deviations in a month (~20-40 bp today), S&P 500 returns have typically been flat. When bond yields have risen by more than 2 standard deviations in a month (~40+ bp), S&P 500 returns have typically been negative (see Exhibit 3).”
The other consideration is that growth stocks naturally have very highs PEs and tend to do well when inflation is low. The NDX clearly outperforms the SPX when the yield curve is flattening, but when it steepens, as it did during the 2013 taper tantrum, SPX outperforms.
In recent weeks and months the curve has steepened again and FAANG stocks particularly have underperformed. Nomura’s McElligott has recently warned that “secular growth ‘hiding places'” such as FAANG stocks “were accumulated from the lazy multi-year ‘slow-flation’ U.S. economic narrative and are now being reduced.”
This is a good time to remind readers it is not the flattening or inversion of the yield curve that is typically problematic for stocks and the economy – stock markets tend to rally during the flattening – it is the steepening which lead to problems.
With the yield curve steepening from a near inverted state, and talk of the Fed reaching the neutral rate and the end of its hiking cycle, there is a realization that we are likely nearing the end-game of this cycle. Again this has some parallels with the end of 2014 as QE finally came to an end. Technically they also compare as the final correction in a trend sequence before the last (wave 5) rally.
The price action around the end of QE shows why this period, combined with 1929, will guide us into year end.
Markets are multidimensional and subject to the variable impact of FITS. History shows why this week should provide immense opportunity into year end—and indeed the endgame.
Here’s to making the very best.
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