Remember the “everything rally”? It was a big thing in 2021, as investors clamoured for the absurd returns to be made in any assets they could get their hands on, whether they were stocks, bonds, commodities, or NFTs of bored apes.
Well, it’s back. The last month has seen the same kind of all-encompassing buoyancy overtake financial markets across virtually all geographies, asset classes, styles and sectors.
Sensing victory in the fight against inflation, traders have electrified financial markets with the growing belief that big cuts to interest rates are coming soon.
The problem with this market-wide prophecy is that it could be self-defeating.
Longer-term bond yields, which act as pegs for all sorts of debt products, from auto loans to corporate bonds to mortgages, are way down over the last month.
The benchmark yield on Canadian 10-year government bonds dropped by nearly a full percentage point from its October peak of 4.2 per cent, before ticking up to 3.4 per cent by the end of the week. The U.S. 10-year yield over the same period has fallen to 4.2 per cent from 5 per cent.
Those are giant moves by treasury market standards, and they effectively wipe out two months of tightening in financial conditions.
It is now cheaper for consumers and corporations to borrow money, which can cause the economy to pick up speed, thus undermining the central banks’ campaign against inflation. The whole idea behind rate hikes is to discourage borrowing.
Up until this reversal, markets and central banks were on the same page.
Investors heeded the warning that interest rates would likely need to be higher for longer in the face of sticky inflation.
This sent bond yields skyward, with the U.S. 10-year breaching the 5-per-cent mark for the first time since 2007. This is what a bear market in bonds looks like: As yields rise, existing bonds with lower coupon rates are worth less.
U.S. yields climbed so much, in fact, that 10-year Treasuries lost roughly 25 per cent of their value from July, 2020, up to late October of this year, which is thought to be the worst rout in American history.
The rise of interest rates and bond yields from the ultralow levels of the pandemic has been the dominant force in the investing world for two years now.
Last year came the brutal reckoning across the spectrum of risk assets. This year has been more of a slow sideways grind.
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While the S&P 500 and Nasdaq Composite indexes have registered strong headline gains, a handful of tech giants have been responsible for almost all of the upside. Excluding the group known as the magnificent seven, stocks globally were essentially flat for the first 10 months of the year. The S&P/TSX Composite Index was down by 3 per cent. Commodities as an asset class lost roughly 7 per cent.
But as inflation has receded from developed economies, a sea change in investor sentiment began.
November saw risk appetite come back forcefully.
The TSX rose by 7.2 per cent, with every single sector of the market registering a positive result on the month. Canadian government bonds rose by 3.5 per cent, as did U.S. Treasuries – their best monthly result since 2008. Factor in corporate issuers, and the U.S. bond market had its single greatest month since the 1980s.
Also posting gains on the month: European stocks, emerging market stocks, precious metals, small-caps, large-caps, growth stocks, value stocks, REITs, high-yield debt, unprofitable tech and cryptocurrencies. The only major exception was oil prices, which have dropped sharply over resurgent U.S. production and the potential for lower global demand.
That kind of synchronized ascent in asset prices suggests a growing confidence that inflation has been conquered and rates are headed downward.
While central bankers continue to talk tough, the markets are just not buying it any more. The two sides, in fact, seem to be operating in completely different realities.
On Wednesday, the Bank of Canada held interest rates steady, but warned that additional rate hikes are still on the table. Meanwhile, Benjamin Tal, the deputy chief economist of CIBC, said this past week he expects 150 basis points of rate cuts in Canada in 2024 – the equivalent of six 25-basis-point reductions to the policy rate. (A basis point is 1/100th of a percentage point.)
Traders are also projecting aggressive rate cuts by the U.S. Federal Reserve in the coming year. Rapidly cooling inflation should allow the Fed to cut its federal funds rate at every one of its meetings, beginning in March, Paul Ashworth, chief North America economist at Capital Economics, said in a note. That would bring the key U.S. interest down by 225 basis points by early 2025.
Meanwhile, the Fed has not even acknowledged that rates have risen high enough for its liking. That messaging is unlikely to change with the Fed’s next rate announcement on Wednesday, especially after the dramatic turn in bond yields effectively loosened financial conditions.
“The Fed may not be quite ready to abandon its tightening bias … but the markets are no longer buying its ‘higher for longer’ mantra,” Mr. Ashworth said.
Note to investors: Wish too hard for rate cuts, and you just might not get them.
Tim Shufelt