Will the perceived Goldilocks economy continue? Oil prices are surging. The auto industry is facing an unprecedented strike. The government may shut down. The global economy is in a major transition. Interest rates are at 15-year highs. The deficit and the interest costs on this deficit are exploding. And then there is the political scene.
And these are just the topics in mainstream media.
It is often penned the markets require a “wall of worry to move higher.” Are all the above priced into equities?
Longer dated Treasuries continued their selloff as weekly jobless claims fell to the lowest levels since January. Claims were significantly lower than any Bloomberg estimate, perhaps invalidating the view that the low number of claims during the two previous weeks were artificially deflated because of Hurricane Idalia. [Note: Major storms often depress claims at first]
As noted many times, interest rates are a major determinate of valuations and if inflationary expectations increase, values will decline if corporate cashflows do not have a corresponding rise.
What is the neutral rate or the percentage amount that the risk-free rate must be over the prevailing inflation rate? What is the expected inflation rate?
The Federal Reserve’s central tendency of the neutral rate is now 0.6% to 0.8% over the prevailing inflation rate. This is almost double the rate from six months ago.
Inflation is expected to increase for the remainder of the year.
The expected environment is now beginning to be priced into longer dated Treasuries. The imperative question is whether longer dated Treasuries will fully price in today’s inters rate environment and how such a repricing will be reflected in the equity markets.
Legendary bond investor Bill Gross warned yesterday the Treasury market is headed for an unprecedented third year of losses because of sticky inflation and widening deficits, a result of government fiscal spending he equates with “throwing money out of a helicopter.” Treasuries declined by a record amount in 2022.
Gross commented he is concerned that more than 30% of the $33 trillion in Treasuries outstanding will mature in the next 16 months, an environment amplified by QT or the Federal Reserve selling about $1 trillion of its bond holdings during the same period. Who will buy the debt?
Historically the 10-year Treasury yields about 1.85% more than the fed funds rate. Even if the policy rate drops to 2.5%, that puts the 10-year around 4.35% or nominally lower than current levels.
The Fed’s “dot plot” suggests the 2024-year end fed funds rate will be around 5.1%, thus suggesting a 10-year yield over 6.90%. If the 10-year yield rises to this level, according to Blomberg analytics the 10-year Treasury will have a negative annual return of over 12%.
Ouch!
Commenting on yesterday’s market activity, Bloomberg writes “all asset classes produced losses yesterday on a Federal Reserve induced hangover.” Longer dated Treasuries sold off which was the catalyst for the selloff in tech stocks and other asset classes.
Last night the foreign markets were mixed. London was up 0.70%. Paris down 0.41% and Frankfurt down 0.06%. China was up 1.65%, Japan down 0.52% and Hang Seng up 2.28%. Dow and NASDAQ futures are up 0.25% and 0.4%, respectively following the lowest close in the markets since early June. The 10-year is up 2/32 to yield 4.49%.
