Over the past week, there has been a significant decline in equity markets due to the anticipated negative impact of higher-for-longer US interest rates, which continues to affect investor sentiment. All sectors showed losses as the S&P 500 fell by 2.9%.
Investors are struggling to cope with a policy-driven structural bond market reappraisal, causing yet another yield reset after the Federal Reserve's messaging emphasized the likelihood of higher interest rates in the future.
Of course, this is nothing new; investors have been trying to consume higher interest rates for some time now. Still, since the S&P 500 hasn't posted any net growth over the last two years, these moves reinforce the ongoing valuation adjustments that investors must consider. The forward earnings yield on the S&P 500 is currently at 5.5%, a mere 100 bps spread above risk-free returns on 10-year Treasury bonds and at the lowest since the early 2000s. Days of the luscious 5 to 6 percent spreads above Treasuries are an era long gone by, possibly marking a regime shift on how investors view their stock portfolio relative to the attractive bond yields.
Risk markets desperately need a run of Goldilocks economic data to at least put back 75 bp of cuts in 2024 vs. the Fed's expectations of only 50 bp and help stabilize the ship.
While it might be too early for the broader market to fade the 2024 Fed dot plot repricing, however, given the economic potholes that lie in wait in Q4, particularly the resumption of student loan repayment, US labour activism and the possibility of another government shut down, bond yields could move in a more risk-friendly direction in the not too distant future.
As we move into fall, which officially started on Saturday, and lurch towards the holiday season, the health of the US consumer will become an even greater focus. How the US consumer can digest these higher rates may be critical to what happens with risk assets into year-end.
Despite the Fed's intent on cooling consumer demand, just as the markets hit the end of US driving season, typically associated with a mini seasonal swoon in gasoline demand and help ease the current oil supply shortage, Russia decided to introduce a temporary ban on gasoline and diesel esports with the later compounding scarcity just as the winter diesel rush looms large.
The diesel/gasoil supply outlook was very tight entering the high winter demand season, driven by voluntary curtailment of heavy crude supply from Russia and Saudi Arabia. And with little offset from the lower diesel/gasoil yields expected from lighter crude, buyers and consumers could be entering a pain period. While the temporary ban will ease growing energy concerns in Russia and member states this winter, you can't help but think Europe is in the crosshairs here.
Hence, oil prices remain supported well within OPEC's perceived sweet spot of $80-$110 per barrel.
Short Cable is in play
Markets initially expected the pound to perform well. Still, the BoE's recent decision to keep interest rates at 5.25% and other economic factors have led some economists to predict no further rate hikes this cycle.
This combination of lower growth, persistently high inflation, and lower real interest rates—presents a challenging mix for the currency. If incoming economic data reveals a more negative growth outlook than expected, Sterling could face even more downward pressure.
It's worth noting that the main factor that could counter further weakness in GBP would be if incoming data surprises the upside, potentially revealing that the recent progress was misleading and prompting the BoE to consider a more assertive response. However, such a shift in policy would likely take time to materialize, so I'm comfortable with a tactically bearish view for now.
The King Dollar
The Fed's updated projections suggest that the US Dollar will remain strong due to a robust economy and labour market. If the current run of robust economic activity persists, the Fed is on record they will raise rates and delay rate cuts. This could weaken the Euro and Sterling, especially with the continent's Central Bank policy heading in the opposite direction.
The Fed's policy reversal bar is high, but market concerns may arise if the anticipated economic "pothole" happens. A more balanced global growth outlook is needed, which requires European and Chinese economic activity to pick up.
The Yen is still all about macro
The Bank of Japan has maintained its current policy stance, with most BoJ watchers still maintaining a dovish outlook. The trajectory of the Japanese Yen will continue to be influenced primarily by broader macroeconomic factors, particularly the outlook for the US economy. Most expect USD/JPY to trend higher, gradually reaching around 150 by year-end, and in the absence of at least abandoning YCC, the pair could march to 155 over the next six months.
While short-lived JPY outperformance is possible on intervention rhetoric, traders would likely view it as an opportunity to position for more JPY weakness, thinking intervention is futile given the wide US vs. JPY yields spread without an actual policy pivot from the Bank of Japan.
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