Stocks Threatened by Looming End of Low Rates

Posted by Mark Pettinga

Last week Ray Dalio, head of the Bridgewater mega-hedge funds, declared that the era in which central banks drove interest rates to zero and created boatloads of liquidity is coming to an end. Their activity pushed up asset prices and drove nominal interest rates below nominal growth rates, which, he writes, “created beautiful deleveragings.”

In turn, Dalio continued, that now has produced “more conventional economic conditions” in which credit and the economy are growing in balanced fashion. Others might aver that this massive monetary experiment has created asset inflation for those sufficiently wealthy to own assets and middling income growth for the rest of the population, but that isn’t the question at hand.

It is whether the process of monetary inflation is being wound down, and on that score Dalio answered in the affirmative. “Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered, rather than increased,” he wrote.

That means the likes of Federal Reserve Chair Janet Yellen, European Central Bank President Mario Draghi, and all the other monetary muckety-mucks will begin to reverse their liquidity largess. In the process, Dalio contends, they’ll attempt to tighten at just the right pace, so that inflation and growth are neither too hot nor too cold, “until they don’t get it right, and we have our next downturn.”

Then, in a remarkable channeling of the infamous words uttered by former Citigroup CEO Chuck Prince 10 years ago, just as the financial crisis was about to erupt, Dalio declared that given the change in credit conditions, “our responsibility now is to keep dancing, but closer to the exit and with a sharp eye on the tea leaves.” (But, apparently, with little regard to mixed metaphors.)

The surge in yields in global bond markets intensified last week, casting a pall on equities, amid increasing anticipation that the tide in central bank policies is turning. The Fed, of course, last month raised its key policy rate for the third time since December, as had been widely anticipated.

The volte-face by the ECB’s Draghi in declaring victory over deflation wrong-footed bond bulls. The benchmark German 10-year Bund’s yield more than doubled from its recent lows, to an 18-month high of 0.58% on Friday. Such a yield once was thought to be unimaginably low, but it is a marked rise from the subzero levels of last year, and resulted in steep price losses for holders of the securities.

But the ripples extend far beyond the European bond markets. The benchmark 10-year U.S. Treasury’s yield has jumped 25 basis points (one-quarter of a percentage point), to Friday’s close of 2.39%, from its recent low hit on June 26. Since then, the major U.S. stock averages have drifted down about 1% from their peaks, with the tech-laden Nasdaq slipping 2.6%. The interest-rate impact is clearest in the Dow utilities, which are off more than 3% in the past month, while the Philadelphia Semiconductor Index, a leading tech indicator, has shed about the same amount.

Fed watchers anticipate that Yellen may announce the beginning of the wind-down of the central bank’s balance sheet, to begin later this year. In her press conference following last month’s Federal Open Market Committee meeting, she suggested that redemptions of Treasury and agency mortgage-backed securities should run “quietly in the background.” But Richard Koo, chief economist at the Nomura Research Institute, is a skeptic. If the Fed stops rolling over its holdings, he asserts, the extra $600 billion in securities the market will have to absorb in 2019 and 2020 would be equivalent to a doubling of the federal budget deficit.

Jim Paulsen, speaking from his new perch as chief investment strategist at the Leuthold Group, thinks the Fed would do well to raise rates and shrink its balance sheet before it hurts Main Street. Real rates (that is, after inflation) are still negative. Another worry is that the dollar has turned south as the Fed has boosted borrowing costs. That could feed inflation, which has remained below the central bank’s 2% target.

All of which could push the 10-year Treasury yield to 3%. The Standard & Poor’s 500 index, now at 2425, could rise toward a peak of 2600, a precarious level with those bond yields, he continues. Paulsen suggests that could produce a decline along the lines of October 1987, albeit less severe. (Remember, the Dow Jones Industrial Average crashed 22% on Monday, the 19th of that month.)

Federal-funds futures are pointing toward another 25-basis-point Fed hike in December, with the balance-sheet slimming commencing in the fourth quarter. Yellen is likely to be asked about that when she makes her semiannual trek to Congress this week to testify on monetary policy and the economy.

As for the latter, the June employment data released on Friday was roundly deemed as strong. Nonfarm payrolls expanded by 222,000, topping forecasts of about 178,000, with upward revisions totaling 47,000 for the prior two months. The jobless rate did tick up, to 4.4% from 4.3%, partly owing to rounding, but also for the positive reason that more folks entered the workforce.

But the numbers didn’t pass the smell test, at least not for the sensitive nostrils of David Rosenberg, the chief economist and strategist at Gluskin Sheff. The least pleasant odor came from continuing slow wage growth, which remained tepid, at 2.5%, year on year. More worrisome was the continued exodus of prime-age (25 to 54-year-old) men from the workforce, some 21,000 in June, after 92,000 in May.

At the same time, Rosenberg observes an influx of 203,000 kids, age 16 to 19, into the workforce and a 178,000 rise in the “aging, not aged” baby boomers over 55 who must keep working to maintain a lifestyle they can’t afford on their depleted retirement savings. He also notes a 5.2% rise in multiple-job holders in the past year, a sign of folks needing more income to make ends meet.

That doesn’t jibe with hedge fund honchos’ vision of dancing while the market’s music plays on. The notes are more discordant in much of the rest of America. Randall W. Forsythe, Barron’s, July 8, 2017.