This morning I was greeted with the following alert from Bloomberg news on my iPhone:
“Coronavirus infections still rising, Fed reduces repo operations, and euro-area economy stagnates. Here’s what’s moving markets.”
I should have been surprised that, despite the trifecta of gloomy headlines, US index futures were trading up about 0.2%, but I wasn’t. That sort of thing doesn’t surprise me anymore. Stock markets seem to have taken on a life of their own, beholden only to money flows and positive sentiment.
It is for that reason that I now consider myself a “market nihilist”. For those with neither a philosophical bent nor a love of “The Big Lebowski”, allow me to define the term. Nihilism, derived from the Latin word for “nothing”, is defined as a philosophy of “extreme skepticism maintaining that nothing in the world has a real existence.” While I hardly espouse that view in my daily life, I have come to realize that if we substitute “market” for “world” in the prior definition it pretty well sums up my attitude towards recent market activity.
I have written here before (links below) about my belief that world markets – equity and fixed income – are being driven by waves of central bank liquidity. The most recent wave in the US was driven by a sharp increase in the size of the Federal Reserve’s balance sheet during last year’s fourth quarter as the result of the Fed intervening to provide a backstop to the fragile repo market. For that reason, I am shocked by the lack of response to the Fed’s decision to reduce the size of their repo operations. We see, however, a 2-4-week lag between the stock market and the Fed balance sheet, so perhaps it is not unreasonable to see the market shrugging off that news in the short-term:
As for another central bank in the news, we see that the People’s Bank of China (PBOC) has begun to withdraw some of the massive liquidity that it injected in the face of the covid-19 outbreak, though not enough to fully offset the increase:
And while the US equity markets charge towards new highs, reflecting rosy prospects for corporate America, the treasury yield curve is telling a vastly different story:
The two lines on the above graph compare the active treasury yield curves from today versus one month ago. We see a major parallel shift to lower yields from the 2-3-year maturities on outward, while the front end of the curve has slipped back into reversion. Neither of these bode well for the economic outlook. The decrease in bond rates implies lower inflationary expectations, while the inversion in note rates implies the need for Fed easing within the coming years. Over the course of my career, I have found that when stock and bond markets disagree, the bond market is more likely to be proven correct.
There is only one way I can reconcile such glaringly different economic outlooks – the flow of money. Money flowing into markets raises prices, which has the effect of lowering bond yields. We see the Fed and PBOC pumping money into the system (along with accommodation from the European Central Bank and the Bank of Japan). Increased money supply should lead to inflation somewhere. Their efforts to produce real-world inflation have been generally unsuccessful though –as reflected in stagnant commodity prices. The inflationary effect is instead being seen in financial markets.
This leads to my nihilism, my belief that little else matters besides central bank liquidity. Markets seem addicted to that liquidity and behave well as long as global central banks are willing to provide it. My biggest fear right now is how bad the markets would react if central banks fail to feed that addiction.
For further analysis, please view the following links:
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