Four links in the global financial market chain have weakened: which is next?


This week this column is indebted to two charts it saw last month while listening to Fidelity’s vastly experienced fund manager Ian Spreadbury at a conference. This is not to put words into Mr Spreadbury’s mouth – he needs no help on that front and any views expressed here are strictly those of this column, but credit must be given where credit is due.

This is the first and it shows the yield on the benchmark 10-year US Treasury, or Government bond. This column is no chartist but this could be seen as a decisive break-out above the 3.05% level.

Has the yield on 10-year US Treasuries decisively broken out to the upside?

Source: Fidelity International, Thomson Reuters Datastream

There are three possible explanations for this apparent shift in bond market momentum:

  • Fixed-income investors are still wary of the potential for inflation to surprise to the upside, especially as oil prices march higher.
  • An annual US budget deficit that is expected to reach $804 billion in the year to September 2018 and $981 billion to September 2019, compared to $665 billion in 2017. The US Government has to sell more bonds to fill the gap and greater supply means it may have to offer a higher coupon to tempt buyers.
  • The US Federal Reserve’s switch from Quantitative Easing (QE) to Quantitative Tightening (QT). The Fed will reduce QE by $30 billion a month this quarter, $40 billion a month from July and $50 billion a month from September. The end of QE removes a huge buyer from the bond market just when supply is going up.

Where US 10-year yields end up remains to be seen but it may not be a coincidence that certain riskier and more speculative areas of the financial markets appear to be coming under duress just as the returns from a purportedly safe asset (and one priced in the globe’s reserve currency for good measure) start to look more tempting.

Four quick hits

In quick succession, Bitcoin, low-volatility trading strategies, high-flying technology stocks and now emerging markets (and especially emerging market currencies) have at least stumbled or in some cases been routed.

Bitcoin has tumbled....

Source: Thomson Reuters Datastream

...while low-volatility strategies have been caught out...

Source: Thomson Reuters Datastream

The sudden reversals in the Turkish lira, Indonesian rupiah, Mexican peso and Argentine peso all suggest that investors are, slowly, starting to become more risk averse, especially after their experiences with Bitcoin and trading the VIX index and an initial wobble in tech.

....even as tech stocks are trying to recover their poise...

Source: Thomson Reuters Datastream

...and emerging market currencies are coming under the cosh

Source: Thomson Reuters Datastream

Any chain is only as strong as its weakest link. Whether this is a warning of further trouble to come in more mainstream assets, such as UK and US stocks, remains an open question, but then no-one could have imagined that a downturn in Florida’s housing market and the collapse of two obscure hedge funds in 2007 would be the first stages of a two-year financial panic and bear market in share prices.

Domino effect

None of this mean that indices like the S&P 500 and FTSE 100 are destined to plunge soon but the combination of low volatility, lofty valuations (especially in the USA), and rising interest rates (at least in the USA)  is a potentially tricky one.

The good news is that earnings forecasts are still being met or exceeded, so estimates are rising.

Real, near-term trouble for advisers and clients with substantial exposure to equities could come in the form of a global economic slowdown – or even an actual downturn – as that would hit corporate profits.

That in turn would leave valuations looking too rich, based largely as they are on the assumption that record corporate profit margins will stay high or go higher, and also potentially expose dividends to cuts as companies see their earnings and cash flows start to diminish.

And this is where Mr. Spreadbury’s second chart comes in.

It shows the US 10-year Treasury yield minus the Fed Funds rate. On the three occasions when the Fed’s target rate has exceeded the 10-year Treasury since the 1990, a US recession quickly followed, in 1990-91, 2001-02 and 2007-08. (This indicator also proved accurate with the double-dip downturn of 1979-1982 but the chart below does not go back that far.)

If the Fed’s target policy rate exceeds the 10-year Treasury yield then history suggests the US economy could stumble

Source: Thomson Reuters Datastream

This is not a prediction for 2018 and the good news is that the US 10-year yield of 3.11% still comfortably exceeds the 1.75% Fed target rate.

But if the Fed sticks to its script with two or three more increases that year that could close, to suggest that advisers and clients need to keep a very close eye on both the Fed and the US bond market as this year develops.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.