The Fed is backing down on its ultra-easy position. Volatility can follow.
It’s summer, but life may not be easy, at least for the financial markets.
The summer solstice arrives in the northern hemisphere on Sunday at 11:31 p.m. EST, and the top priority for anyone locked in by Covid-19 is to get out and go somewhere, anywhere. In the old days, this usually meant financial markets were slumping, which sailors associate with the season. This is less and less the case in recent years, and this summer promises to be less peaceful for the markets.
Credit or blame the Federal Reserve, which last week signaled a possible move away from its current ultra-accommodative monetary stance. While the Federal Open Market Committee has made no current policy changes, its so-called dot chart of members’ assumptions about the future federal funds rate target showed two quarter-percentage-point increases d ‘by the end of 2023. In its previous round of bulletins released at the March meeting, the midpoint still had the Fed’s key rate at the current 0% to 0.25% range in more than two years. Granted, Eurodollar futures already had several rate hikes at that time, so in essence the points were marked against the market.
Specifically, Fed Chairman Jerome Powell admitted that monetary officials have finally started talking about cutting back on his massive bond purchases, consisting of $ 80 billion in Treasuries and $ 40 billion. agency mortgage-backed securities each month.
In other words, the Fed’s super easy monetary policies, which were put in place in March 2020, at the height of the economic and financial chaos brought by the pandemic, will have an eventual expiration date. With the US economy growing rapidly and inflation reaching multi-year highs, the time for these emergency policies seems to be running out. Yet the admission of this seemingly obvious fact took the markets by surprise.
Recalling the “taper tantrum” launched by bond and stock markets in 2013, when the Fed last announced its intention to cut back its bond buying program, Powell made it clear that the Fed would notify markets well to advance. Nonetheless, the introduction of this uncertainty means that some increase is likely in recent moderate market volatility.
“With the equity markets [at the index level] being in an almost catatonic state, it is inevitable that volatility will accelerate, ”remarks Julian Emanuel, chief equity and derivatives strategist at BTIG, in a telephone interview. the
Cboe volatility index,
or VIX, was mostly stuck as a teenager, according to sleepwalking stock trading, for about three months.
This roughly coincides with the capping of long Treasury yields after their sharp rise in the first quarter and the gradual decline from a recent high of 1.75% on the benchmark 10-year bond to less than 1.50%. . This was contrary to widely held predictions that longer-term bond yields would continue to rise towards 2% on the 10-year Treasury.
And the Fed’s announcement that it had started talking about cutting bond purchases, along with a possible hike in interest rates, triggered an immediate rise in bond yields. But then things got a little weird in the bond markets on Thursday during the day two reaction to the FOMC meeting.
Rates rose in the short end of the market as the yields on maturities of more distant yield curves fell, causing the slope to flatten overall, writes William Naphin, interest rate derivatives strategist at RJ O’Brien. , a Chicago institutional brokerage. , in a customer note.
In the Treasury market, the two-year note – the coupon maturity most sensitive to the Fed’s rate expectations – rose 0.226%, the highest since March 2020, from the level of around 0, 15% to which it has been blocked for more than three months. Over the long term, however, the 30-year bond yield fell to 2.104%, its lowest level since Feb. 18.
Such a discrepancy has been rare in recent years. While money market rates have risen and Treasury yields have fallen 33 times since 1995, this has only happened once since 2011, he adds. Such episodes were quite common during the period 2001-03, when the Fed was also in an emergency political position during the recovery from the recession that followed the bursting of the dot-com bubble.
The hedging of mortgage portfolios against rising interest rates (by taking offsetting positions in treasury bills or derivative products such as futures and options) was then passed on to the markets. It’s less relevant now, but there was no risk of a Fed tapering back then. Anyway, remembering this episode, Naphin concludes that he now wants to bet on higher volatility than lower.
For his part, Emanuel dismisses the bond move as a side effect of the commodity slump that followed the Fed news, calling it a “tail wagging the dog.” Owning raw materials has been an extremely crowded business, he adds, which has been corroborated by
Bank of America‘s
monthly survey of fund managers released earlier this week.
Regardless of its base, the pattern of a flatter yield curve, lower prices for previously hot commodities such as copper, as well as a stronger dollar that followed FOMC announcements and comments from Powell. after the press meeting, everything points to a disinflationary direction.
They also suggest further acceleration in volatility with a likely increase in Fedspeak volume among central bank governors and district presidents in the coming weeks. The first of these was the always talkative St. Louis Fed chief James Bullard, who on Friday suggested that the first rate hike could take place as early as next year, making him one of the seven points of the FOMC who expect a takeoff in 2022.
The consensus appears to be that Powell will unveil the Fed’s plans to slow down its buying of securities at the big policy conference in late August in Jackson Hole, Wyo. For his part, Emanuel believes the FOMC should announce something at its next meeting on July 27. 28. “If not now when?” he asks.
In particular, calls for the Fed to slow down or even end its $ 40 billion monthly purchases of mortgage-backed securities have become widespread. On this point, Bullard seemed to agree. “I’m leaning a bit towards the idea that we maybe don’t need to be in mortgage-backed securities with a booming housing market,” he said. “I would be a little concerned about feeding into the housing foam that seems to be growing.”
Even without the Fed curbing its bond purchases, which pushed its balance sheet over 8 trillion dollars Wednesday, nearly double its pre-pandemic size – Lori Calvasina, head of US equity strategy at RBC, believes the decline in the 10-year Treasury yield in the second quarter could be a sign of a slowing economy. This thesis was proposed in this space a week ago.
The slippage in long Treasury yields could portend a collapse in widely watched ISM indicators, which she said could be associated with either a pause in cyclical stock leadership or a pullback in the overall market. In this case, she suggests adding to classic defensive groups such as consumer staples, utilities and healthcare to overcome a short-term setback. Financials, energy and materials, which were leading the market, still make sense in the longer term, while industrials lack appeal because of their valuation, she adds.
Emanuel also prefers exposure to defensive groups such as Health, as he expects bond yields to rally, with the 10-year Treasury heading towards 2%, posing a headwind for equities. At the same time, it would avoid transports and high secular multiple growth stocks, which are sensitive to higher returns.
And he would play a rise in volatilities with options. In a client note, he recommended a straddle, simultaneously buying call and put options on July 30.
S&P 500 index,
a position that would yield big moves up or down, but that would lose the cost of premiums paid on options if the market remains tied to a range. If July brings fireworks beyond the fourth, however, the bet would be a winner.
The augury – as opposed to reality – of less monetary stimulus from the Fed made it the worst week for the
Dow Jones Industrial Average
since the end of the week on October 30, just before take-off from the market on
(ticker: PFE) vaccine breakthrough in early November. the
settled on Friday just below its 50-day moving average, a level that has mainly been maintained since this good news suggesting a possible end of the pandemic.
Raising games, such as
SPDR S&P Metals and Mining
the exchange-traded fund (XME), which finished down 12%. By comparison, oil has held up better than other commodities, with crude remaining above the $ 70 per barrel mark for the US benchmark. The BCA’s commodities and energy strategy letter sees a continued rebound in global oil demand combined with a supply restriction due to “OPEC 2.0 production discipline” (including countries that are not formal cartel members, such as Russia) and “the discipline of capital imposed on American shale producers.” BCA sees Brent crude, which is trading around $ 2-3 above the U.S. price, at $ 74 a barrel in 2022 and $ 81 in 2023, from $ 73.51 on Friday.
This could make oil stocks a redoubt among reflation games, which are now moving upside down, and an attractive place for income investors, as his colleague Avi Salzman wrote on Barrons. Elsewhere, Lawrence Strauss highlights energy stocks among income ideas to fight inflation. the
Energy Sector Select SPDR
ETF (XLE) returns 4% over 12 months rolling, almost double that of the 30-year Treasury, which on Friday stood barely above the equivalent of the bond market of the Mendoza line at a yield of 2.02%. More impressive was the cumulative total return of 43.98% of the Energy ETF, according to
The morning star.
Bargain hunters can gain exposure to a similar portfolio in a closed-end fund, the
Adam’s Natural Resources
(PEO), which closed Thursday at a discount of 12.8% to its net asset value, according to its website. The two funds are dominated by two of the big oil majors,
(CLC); these two values represent almost 43% of the ETF and 32% of the CEF. Paying 88 cents for dollar bills has obvious appeal to value investors.
Write to Randall W. Forsyth at [email protected]