Just Another Panic Attack

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by: Calafia Beach Pundit

The S&P 500 has lost about 5% since last month's record high, but it's still up about 4% year to date. It's painful, but still short of a typical correction (-10%). The culprit? News reports cite the 80 bps rise in 10-yr bond yields this year, Fed tightening, rising tariffs, and the flatter yield curve.

I don't buy most of that. Bond yields are still unusually low, and the driver of higher yields is rising real yields, which reflect a stronger economy; why should a stronger economy be bad for stocks? The Fed hasn't even begun to tighten, since the real Fed Funds rate is only slightly above zero; short-term borrowing costs are almost free. The yield curve has flattened, but it is still positively sloped; the all-important real yield curve is still nicely positive-no implied threat there. Rising tariffs are a genuine problem, to be sure, but that's still in the nature of a headwind rather than impending doom. Tariffs can be dismantled as fast as they are applied, and Trump has made good-if hardly perfect-progress bringing down tariffs with Canada, Mexico, and the eurozone. China is the main problem, and it boils down to a big game of tariff chicken. It's in no one's interest to escalate this conflict to outright tariff wars. I remain confident that the future of global trade will be "freer and fairer." The truth about tariffs is that a) they mainly hurt the country that applies them, and b) lower tariffs are always better for all concerned. I'm not ready to bet that Trump and China will refuse to come to an agreement that would be mutually beneficial.

Right now, my best guess is that this is just another panic attack, of which we've had quite a few in recent years. They've all been resolved eventually, as the stock market manages to climb successive walls of worry. This is healthy. It wouldn't be surprising to see prices decline further, but it would be surprising if this proved to be the beginning of a major rout or recession.

Here are some up-to-date charts that focus on key indicators:

Chart #1

The Vix index is the classic measure of investors' fears; the higher it is the more it costs to buy the protection of options. I like to divide it by the 10-yr Treasury yield, since that is a proxy for the market's growth expectations; the higher the yield, the stronger the economy, and vice versa. The ratio of the two is thus a measure of how fearful and doubtful the market is about the future. It jumped Wednesday, but as Chart #1 shows, it is a minor blip from a historical perspective. Note how jumps in the Vix/10-yr ratio always coincide with big drops in equity prices.

Chart #2

Chart #2 shows 2-yr swap spreads in the US and eurozone. Swap spreads are an absolutely key measure of market liquidity and systemic risk (the lower the better). Swap spreads also have proven to be excellent leading and coincident indicators of financial market and economic health. Conditions in the eurozone aren't quite as good as they are here, but conditions in the US are about as good as they get. There is plenty of liquidity, which is essential to ensure orderly markets. With plentiful liquidity, the market can price in and deal with all sorts of problems. Problems arise when liquidity is scarce and markets are thus unable to perform one of their key functions, which is to distribute risk from those who don't want it to those who do. This chart is also prima facie evidence that the Fed is not tightening monetary policy.

Chart #3

Chart #3 compares the prices of gold and 5-yr TIPS (using the inverse of their real yield as a proxy for their price). It's remarkable that the prices of these two distinct assets should tend to move together. Both have been in a gentle downtrend for the past several years. I've interpreted that to mean that market is gradually losing the risk aversion that peaked about six years ago. Confidence is replacing risk aversion, and with rising confidence comes less demand for the safety of gold and TIPS. This is healthy.

Chart #4

Chart #4 shows a popular measure of the dollar's value against other major currencies. By this measure, the dollar has been roughly flat for almost four years. Problems usually arise when the dollar experiences big moves up or down, since that can and often does reflect big changes in monetary policy (tight money tends to strengthen the dollar, and vice versa). This is a good indicator that US monetary policy is not causing significant problems for the rest of the world.

Chart #5

Chart #5 shows the real and nominal yield on 5-yr Treasuries (blue and red lines) and the difference between the two (green line), which is the market's average expected rate of inflation over the next 5 years. Note that inflation expectations have been relatively stable around 2% for quite some time, and especially over the past several months. This means that nominal and real yields are rising and falling by about the same amount, which further means that what is driving the ups and downs in interest rates is changes in real yields. As I've noted many times before, real yields have a strong tendency to follow the real growth trend of the economy. Real and nominal yields are up because the bond market is becoming more optimistic about the health of the economy. Nothing at all wrong with that!

Chart #6

Chart #6 compares the real yield on 5-yr TIPS (inflation-protected securities) with the real Fed Funds rate, which I calculate by subtracting the year-over-year change in the core PCE deflator from the nominal Fed Funds rate. The real Funds rate is the best measure of how "tight" or "easy" monetary policy is. What this chart shows us is that over the past few years the Fed has moved from being very accommodative to now roughly neutral. This is not threatening, especially considering the improving health of the economy. In truth, what would be very worrisome would be if the Fed had NOT raised rates, since that would have given us a weaker dollar and rising inflation.

Chart #7

Chart #7 shows the evolution of the slope of the Treasury yield curve between 2 (orange) and 10 (white) years. Nominal yields are on the top portion of the chart, while the difference between the two (the slope of the curve) is shown on the bottom portion. Note that the curve has been steepening for the past two months. This is prima facie evidence that the Fed is not too tight. Instead, it tells us that the market is expecting the Fed to continue raising short-term rates modestly. If the Fed were too tight, the curve would be inverted, and that would mean the market was expecting the Fed to have to cut rates. There's nothing scary about the current shape or slope of the yield curve.

Chart #8

Chart #8 shows Credit Default Swap Spreads for investment grade and high-yield corporate debt. These are highly liquid and reliable indicators of how concerned the market is about future corporate profits (the lower the better). While spreads have increased a bit of late, this is a mere blip from a historical perspective. Credit spreads are still relatively low, which is another sign that the market is not very worried about the health of the economy.

We likely will learn more about what sparked the current panic attack in the fullness of time. But for now, it looks to me like it's just another one of those unpredictable - and disconcerting - reversals that occurs from time to time. Markets are like that. Things should get back on track eventually, because there is no sign as of now of any serious deterioration in the market or economic fundamentals.