One More Time, We're Gonna Celebrate

One more time Fed chair Jerome Powell used his hearings in front of the Senate Finance Comitee and congress to prop up the struggling stock markets and to push them to new highs. On Wednesday the Dow Jones Industrial Average closed at a new all-time high and also managed to break through the upper trend line. Although the index reversed down on Thursday I suppose that the journey is not over yet.

We could see all the FOMO (fear of missing out) around investors for the last several weeks now and how they weigh into risk assets. Partly this also could explain the loss in (secure) government bonds which continued as well. US 10y treasury yields are near their 1.50 - 1.60 % line already.

Additionally rising inflation expectations play a role there for sure. Many investors expect a mid-term pick up in inflation soon as we can see when we are looking at US 5y Breakeven rates, which are at their highest since 2013.

It's hard to make predictions, especially about the future, Mark Twain once said (allegedly). Therefore there are some investors who think that the markets are overestimating the effect, for example Pimco CIO Dan Ivascyn. Recently he told the Financial Times that he expect that inflation remains subdued because of long-term trends like technological progress and 'weakness of organised labor'.

Rates are still at historic low levels although the may - which is the joke of the story - become a danger to risk assets. For example the Nasdaq Composite, where all those growth stocks are in, has fallen for about 4 % since the mid of February.

Ivascin says that (and I completely agree) that at some point the Fed is going to step in and will try to end the rise in rates at the longer end of the curve. He believes that they will do this by issuing statements instead of more bond buying. Therefore Ivascyn believes US 10y treasuries at 1.50 % are a good level to buy.

This guess was supported by Jerome Powell at the hearing as he assured that 

"The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved'

I am sure that all central banks - the Fed and the ECB as well - have an interest to keep stock markets at current levels and will try to keep rates down. Even the latest rise in rates did not change my view on that. 

To me the central bankers statements seem a little bit schizophrenic from time to time: We all know their statements about how they need to see inflation to go up above 2 % substantially before they could even think about ending their bond buying and low interest rate policy.

However, as soon as rates start to rise and stocks get under pressure, they come out again and again to prevent just that. But it is totally logical that a rise in inflation will lead to a rise in rates. Apart from Jerome Powell, Christine Lagarde also came out this week to assure markets that the ECB is watching long-term bond yields closely, which temporarily caused yields to fall.

The Fed and the ECB are in a dilemma because according to their mandate they need to act when inflation is overshooting by raising interest rates. When it comes to the Fed, it also has a second mandate, namely full-employment. Although inflation expectations rise the situation remains tense on the job market. Following chart is from a great article by Lyn Alden which shows the Fed's dilemma very clear.

Especially growth stocks are hurt by rising rates as their future earnings get less valuable today. The further rates rise, the more a correction in those stocks becomes more likely. 

Lyn writes that 

'Even if we don't assume that they will go all the way back down to their typical valuation levels (who knows), it wouldn't be shocking for either of those two stocks, and countless other stocks like them, to fall 10-20% and then go choppy sideways for a few years with bad 5-year forward annualized returns, as an example.'

All those things let me conclude that the party is not over yet and many are underestimating how long that monetary expansion will last. 

On the other hand there are things which do not add up with the current sentiment: Insider may not be a good indicator for timing but they show that insiders are extremely bearish at the moment. Maybe the party will not last forever.

Another chart by Julien Bittel is also highlighting the strange market environment we are currently in: While CEO Business Confidence is at it's highest since 38 years (less than 2 % since 1976 they have been that optimistic), early indicators show a downward trend. 

It is said that stock market rallies continue until the last bear has thrown the towel. Everyone wants to anticipate in the rally and loads up a lot of risk while doing that. Everyone panics and buys whatever they can get.

The 1.9 trillion dollar stimulus package by the Biden administration also plays a role there. Deutsche Bank estimates that about 170 billion dollars of it may be invested in the US-stock market. The strategists write that

'Retail sentiment remains positive across the board, regardless of age, income or when the investor began trading'

Apart from equity markets commodities also rose strongly since the market crash last year. After the Nasdaq corrected in mid February, commodities are now the best performing asset since the pandemic hit.

Markets are distorted completely at the moment and have decoupled from reality even further since the covid-pandemic started. The main driver behind this is reckless monetary policy and fiscal policy. 

Governments all around the globe tried to keep businesses afloat with new debt issuance to avoid bankruptcies which would be pretty normal in environments like this. Since the start of the crisis, bankruptcies dropped about 25 % relatively to pre-crisis levels. A tsunami of insolvencies may be in the making.

There is no chance, in my opinion, that governments and central banks will be able to reverse course without causing a massive crisis in the job market. Every raise in interest rates would not only put countries under pressure but also firms and households, simply because they cannot afford a higher interest rate environment. 

That is why I think that all the talking about tapering if we are observing a return of inflation is just bogus and simply a try to calm markets. The only way that this would work would be if economies were able to grew substantially in the next coming years and make it possible to reduce debt.

However, this was not happening last time and I am sure it will not happening this time. There is also a diminishing return on newly issued currency. Best example is the United States, which leads me to come back to Lyn's article.  Until 2008 economic expansion has lead to a reduction in government debt.

When the crisis in 08 hit, the US deficit expanded and got reduced again until Donald Trump took office. The Trump administration, as soon as they were sworn in, started to expand the deficit again. In the middle of an economic expansion! Then, when Covid hit, the deficit fell off the cliff...

On the other hand we have seen how long central banks are able to keep the party going as long as they continue to pump liquidity into markets. The fact that this newly issued money stayed within financial markets and did not cause further growth at least hindered the cost of living to go up. 

All this things are expectable according to the Austrian Business Cycle Theory because if central banks suppress interest rates and inject liquidity into markets, production shifts to goods of capital goods of higher order. 

When market participants realize that their actions where caused by wrong assumptions, a flight into real asset sets in. We already can observe this when we are looking at commodity prices. On the other hand, central banks are floating financial markets with liquidity and therefore support prices there. 

With the reopening of the national economies, the resulting economic expansion can still create the feeling of pseudo prosperity. Over time, however, the air is likely to become thinner in both the financial markets and the real economy. However, it will take some time until then. As the song "One More Time" by Daft Punkt says:

'One more time, we're gonna celebrate,
oh yeah, alright, don't stop the dancing,
One more time, we're gonna celebrate,
oh yeah, alright, don't stop the dancing'

 

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.