Interest Rates, U.S. Dollar And Oil Prices - The Rest Is A Sideshow
Goodbye September, a month when virtually all asset classes took it on the chin. The S&P 500 put in its steepest monthly drop (-4.9%) so far in 2023 and hasn’t logged a positive week in over a month. Those viewing the equity market with rose colored glasses will look at the year-to-date gain of +11% on the S&P 500 as an indication that all is well (to each his own), but I view the roughly 1% ytd gain in the S&P 500 after removing the Magnificent7 (Apple, Microsoft, Nvidia, Alphabet, Amazon, Tesla, and Meta) as a more accurate depiction of how tough 2023 has been. Afterall, the S&P 500 equal-weight index is the same group of companies as the market-cap weighted index (just weighted differently), but it is unchanged on the year and down 14% from its peak – how great can things be if this is how the average stock is performing?
The following three charts of higher bond yields, a rising U.S. dollar, and surging oil prices are what’s causing ajeda in the markets at the moment. I’d go as far as saying that nothing else matters and it’s not until the trends in these asset prices flatten out or reverse that we’ll see the pain in virtually every other asset class abate.
The yield on the 10-year T-Note has climbed to its highest level since October 2007 (see chart below). It’s the latest jolt higher where the yield on the 10-year has gone from 4.09% at the end of August to nearly 4.7% as I type – a 60 basis point move in two months – that has some investors (myself included) wondering whether the long-end of the Treasury curve has become unhinged. It’s an open question, but a scary proposition if that is the case. We’re talking about the world’s reserve asset (U.S. Treasuries) unraveling like a risky small cap stock experiencing a liquidity squeeze.
As for the U.S. dollar, it is coming off its 11th consecutive week of gains and making a new high for the year. It’s still 6% below the cycle highs it reached last fall when the Fed was just finishing up its run of 75 basis point hikes (height of the rate of change in the pace of tightening), but the move up to these levels is having a dramatic impact on liquidity conditions. It is also acting as a major pillar in tightening financial conditions. It’s worth noting that the technical momentum is extremely strong with the 50-day moving average having crossed both the 100dma and 200dma.
Like interest rates and the dollar, oil prices have been ripping higher since the end of June. With the 35% rise over the last three months, oil is back to its highest level since last August and is adding to the complexity of inflation dynamics while becoming a larger strain on consumer wallets.
It’s rather amazing that through this +35% rip in oil prices since late June, the rest of the commodity complex has failed to follow suit. This was a one-trick pony. From their nearby peaks we see that wheat (-46%), corn (-45%), cotton (-44%), nickel (-41%), soybeans (-30%), copper (-24%), lumber (-22%), steel (-17%) have all sagged sharply.
Bottomline, a rising cost of capital via higher interest rates, a strengthening U.S. dollar, and surging oil prices are acting in unison to cause a significant tightening in financial conditions and a headwind to global growth. Without some reprieve, let alone an outright reversal, it is hard to see how the ongoing correction in all other asset classes finds its footing. It’s worth noting that these trends are getting long in the tooth on a host of metrics (RSI, sentiment, positioning), just as similar metrics are stacking up as contrarian buy signals for stocks and bonds (RSI, positioning, sentiment…are reaching oversold levels) which could set the stage for a counter trend bounce at a minimum or even a nice seasonal rally that carries into year-end. Speaking of the seasonals, below is a table from BofA Merrill Lynch on the positive seasonal dynamics just around the corner especially when the S&P 500 is entering Q4 with a double-digit return ytd. But make no mistake, the downward pressure on stocks will continue as long as the trends highlighted above remain in place.
In the interest of being forthright, the rest of this missive is mere narrative, entertainment, and/or thinking out loud from this humble analyst. What I pointed out above is what matters for markets at the moment, so those checking in for the important stuff can stop reading right here – the rest of this commentary, while unquestionably riveting, just isn’t as important.
Over the weekend Congress approved a short-term funding bill to avert a government shutdown. It’s a 45-day continuing resolution to keep the government open which does nothing more than kick the can down the road for the next funding deadline on November 17th. Yippy, we can all get front row seats for the next iteration of political officials using the federal budget as a negotiating chip.
As for the economy, we’re looking at a global growth backdrop where Germany is heading into a recession again and set to drag the rest of the continent along with it. China looks to be doing the same in Asia where there is some excitement that the policy tweaks out of Beijing will kickstart an economic rebound, but so far, such efforts have fallen flat on their face. The problem for China is that you can’t address a solvency problem (there real estate market is imploding) with policies aimed at improving liquidity. With economic growth turning down in Europe and struggling to get off the mat in China it puts a lot of pressure on the U.S. economic engine to carry the load for the globe.
As for the Fed, it looks like we are getting to the point where their tightening efforts are finally starting to bite. Keep in mind that the Fed’s primary goal when moving monetary policy from accommodative to restrictive is to take the proverbial punch bowl away. One of the ways it has accomplished that in this tightening cycle is by creating an alternative to risk assets that asset owners haven’t been privy to in nearly a decade-and-a-half. The short end of the Treasury curve yielding +5% and money markets just below that are arguably a superior alternative to the potential returns in the equity market given current fundamentals. Investors have taken notice with the flow of funds data showing investors have poured $1 trillion so far this year into money market funds (why not with yields near 5%) while inflows into equities are close to flat.
One thing weighing heavy on the Fed in its quest to slay the inflation dragon is this notion of a wage-price spiral. No doubt these worries have intensified over recent weeks with the high-profile wage settlements procured by various union workforces. American Airline pilots secured a 46% pay hike over the next four years. The Teamsters negotiated a five-year deal for UPS workers with a 48% raise. Now we have the UAW demanding a 36% wage increase for the next three years along with a shortened workweek and a revision to COLA clauses. This complicates the Fed’s path in that they can’t run the risk of appearing soft on inflation at a time when this level of wage raises are being agreed to.
I think it would be a mistake for the Fed to use these agreements as a proxy for the entire labor market, but they’re not me and I’m not them. At the end of the day the Fed is highly attentive to its credibility and inflation expectations. If there is a risk that these settlements empower the non-unionized sector to go to their bosses in pursuit of outsized pay increases, then that presents a problem for the Fed. Never mind that there are only 1.8 million members of the Teamsters, APA (pilots union), UAW, and the Culinary Union (threating to strike Las Vegas hotels and casinos) in a labor force of 168 million. It’s this perspective that makes me think the Fed should consider these wage developments as one-offs rather than a representation of the whole. But I can also appreciate their interest in wanting to be vigilant in monitoring the wage situation as a whole.
Before closing this missive, I want to touch on a couple of things I stumbled across in my research that illustrate the impact higher interest rates are starting to have on businesses and the real economy. You know, examples of the ‘long and variable lags’ of interest rate hikes working their way through the financial system.
In the latest CFO survey from Duke University for Q3 nearly 40% of business executives said that high interest rates have caused their businesses to pull back on spending. Another 7% said they would curtail spending if rates were to remain at current levels for another year. Today’s WSJ included an article “Bankruptcies Increase for Small Companies” also highlights the impact higher rates are starting to have. The article states that nearly 1,500 small businesses filed for Subchapter V bankruptcy this year through the end of September (nearly as many as in all of 2022) according to the American Bankruptcy Institute.
A talking point often rattled off by the bulls is how the interest rate impact on corporate America is minimal because the corporate sector locked in low borrowing costs just like homeowners. One big difference between the two is the maturity schedule of corporate debt is much shorter than a 30-year fixed rate mortgage. But that aside, what gets lost in the aggregate data in regard to the strength in corporate balance sheets is that the data is highly skewed toward large cap companies – big cap tech in particular. Debt-service costs for S&P 600 companies (a small cap index) just hit a record high and 30% of Russell 2000 corporate debt is in floating rate debt – that is five-times the share in the S&P 500. This is a ticking time bomb for banks where default rates at small-cap companies are likely to rise at the same time that defaults on commercial real estate, credit cards, and auto loans are spiking.
Let me sign off with a thought-provoking tweet from Michael Green, Chief Investment Strategist at Simplify. For anyone unfamiliar with Mike’s work, he is one of the pioneers on the structural impact the mass adoption of passive/index investing is having on markets. Please check out his work – you will not be disappointed. The below tweet raises an interesting thought. If more and more investors are relinquishing active decision-making from the investing process (choosing instead to participate in a default election option like a target-dated fund or some other form of index participation) but yet the target dated fund does not have built into its algorithm the ability to make an active change to its allocation as fundamental drivers change – then will markets ever mean revert or self-correct misallocations of capital? While investing is not physics this does cause one to ponder Newton’s 1st law of motion where an object in motion will remain in motion unless acted upon by an equal and opposite force. The market forces of passive adoption are becoming so large and dominant that it’s worth contemplating what happens if we’ve passed the point where an equal and opposite force exists?
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