THE BOND MARKET IS DRIVING THE BUS

Stocks opened sharply lower today (Dow -590 pts; SPX -2.1%). Financials and energy are leading the market lower, down by over 3% in early trading. The only sector in the green is utilities, up .4%. The SPX is still about 1.5% higher than it fell on Monday August 5th, so this is not even the worst day for stocks this month. Machine trading has taken over in reaction to falling yields in the bond market, and also lower trade volume. The VIX Index climbed back to 21, but that’s pretty tame compared with the spike above 35 we saw last December. As opposed to yesterday, everyone wants to be first to call the next recession. Scanning Bloomberg headlines, we see the following:

“Bond Panic Pummels Banks with Global Recession Fears…”

“Countdown to Catastrophe? The Yield Curve and Stock Bull Markets”

“Recession Worries Pile Up for the Battered Global Economy”

The yield on the 10-year Treasury Note (1.58%) very nearly fell below that of the 2-year Treasury yield (1.56%). In Wall Street jargon, the yield curve is inverting. This is an abnormal condition which is often followed by economic recession within two years. Inversion is usually brought about by Fed interest rate hikes (which affect short-term rates) coinciding with falling inflation expectations (which affect long-term rates). In other words, recessions are usually caused by the Fed tightening financial conditions at the same time the economy is slowing down. However, the current situation is not so neat, and may not rhyme well with the past. Following an ill-advised rate hike in December 2018 the Fed quickly about-faced and is now cutting rates. Further, the Fed’s stated goal is to use stimulus to extend this economic cycle. Also, investors and economists aren’t so sure that Treasury yields are falling solely due to lower growth & inflation expectations. In fact, even with a higher than expected CPI reading this week, rates kept falling. One key reason is that investors overseas are buying up US Treasuries at a rapid rate because of the relatively high yield compared with many other developed nations. Another reason is widespread fear of an unresolved trade war between the US and China.

In a brief interview yesterday, President Trump explained the reason for delaying implementation of new trade tariffs on some Chinese imports. “We are doing this for Christmas season, just in case some of the tariffs would have an impact” on consumer spending. In a way, this is a very encouraging statement, proving that the president is cognizant and wary of the negative effect of a full-blown trade war. It implies he won’t be reckless with the economy. On the other hand, by admitting pragmatism, he may have just ceded his advantage in the trade war to the Chinese. Hedge fund manager Kyle Bass says, “It does look like President Trump has blinked.” Jim Chanos asks, “…tell me why Xi should not continue to wait out The World’s Greatest Negotiator…?”

Leuthold’s Jim Paulsen sees this stock market dip as a “correction along the way.” He believes investors are “…overplaying the negative impact of trade and underplaying global stimulus” (gov’t deficit spending, money supply, rates).


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