A pause after running ‘too far, too fast’

Consolidation defines the current market tone and this reflects a couple of things. Equities have bounced sharply and other asset classes have also travelled quickly of late, or what traders call a case of “too far, too fast”.

With a number of asset classes pausing for a bit of a breather, the tone of consolidation also reflects the proximity of the Federal Reserve’s latest policy meeting which concludes on Wednesday.

For all the understandable optimism generated by easing rates of Covid-19 infections and the restoration of economic activity, much of the rebound in risky asset prices owes plenty to the very aggressive easing implemented by global central banks, with the Fed clearly the pace setter.

Christopher Dembik at Saxo Bank highlights how the injection of liquidity from the Fed in recent months has elevated its balance sheet by more than $3tn and he expects the balance sheet nears “$10tn by the end of the year, which represents roughly 50 per cent of US GDP”.

Now I certainly did not think back in March that the S&P 500 would be positive for the year as soon as June. Or that some of the most indebted companies would bounce so hard from their lows as this chart via Capital Economics highlights.

Where the Fed has moved the needle for risk appetite is through its backstopping of credit markets. Stemming a credit crunch in the very important area of capital markets — indeed the Fed’s actions has triggered an avalanche of debt sales from companies since March — certainly helps the equity market, particularly the weakest links.

Capital Economics observes:

“Highly-leveraged firms’ shares usually outperform when the spreads of firms with poor credit ratings fall by more than those of firms with good credit ratings.”

They think a steady improvement in the economy along with ongoing support from the Fed entails a lot more compression in credit risk premiums from here.

More to the point, the Fed has the capacity to upsize its presence in credit as the US central bank has achieved a great deal in terms of market influence merely through signalling its intentions, underlining the power of its sway with investors and the financial system.

Marc Chandler at Bannockburn Global Forex notes:

“Many of the facilities that the Fed announced in March and April have yet to be launched, like ones for the corporate bonds and business loans.”

It’s truly an extraordinary time to be covering markets and trying to make sense of matters. At least I’m not alone in being humbled by the ebullient market price action, judging by the analyst and investor comments I hear in conversations and read via some research notes.

Many also highlight how Warren Buffett’s sale of airline stocks has been followed by a ferocious rally in the sector — until Tuesday’s pullback — while other big and very successful investors such as David Tepper and Stan Druckenmiller have been notably cautious about buying into the equity rally from its recent lows. The surge in share prices of recently bankrupt US companies such as Hertz, suggests a speculative excess that only ends in tears. There’s a recovery trade in bonds, not in the shares of a bankrupt company.

Ultimately caution may well prove correct, and that means keeping a judicious eye on credit markets and commercial real estate — a task clouded by the Fed’s support of credit — over the coming quarters.

Even in this regard, some warn that a comparison with the wave of defaults seen during the financial crisis are misplaced. Steven Ricchiuto at Mizuho Securities says:

“What is important to understand is that the liquidity being provided to the economy by the Fed and the Treasury will ensure that these credit events will remain symptomatic and not become systemic. Memory of the financial crisis still lingers in the market’s collective consciousness, and the systemic nature of the credit problems that caused the Great Recession appear to be clouding how investors react to reports of a pending corporate bankruptcy.”

In the meantime, investors are left gauging the likely direction of travel from here, after powerful shifts in asset prices and the likelihood of massive support via fiscal and monetary agencies sticking around for some time to come.

The current market action shows hefty resistance across a number of big levels. Momentum that has driven equities higher looks stretched via various measures and a refrain of profit-taking accompanies the current pullback in share markets. Notably, the defensive qualities of big tech is in play once more, limiting Wall Street from a broader drop on Tuesday. Fresh peaks for Amazon and Apple helped drive the Nasdaq Composite at one point beyond 10,000 points for the first time.

The US 10-year yield retreated further after its recent run above 0.9 per cent. This tone was already established before the sale of an additional $29bn in 10-year notes via Tuesday’s reopening auction of the current benchmark. Investor demand for the sale was softer than usual, reflecting the recent drop in yield.

In the currency space, the euro has been unable to close above $1.13 for two consecutive days, while a global barometer of risk appetite, the Australian dollar, has failed to push beyond 70 cents, its high at the start of the year.

How long this tone extends should become apparent once the Fed’s policy statement and ensuing press conference from Jay Powell are absorbed on Wednesday.

The general take is that the central bank will underline its intention to keep interest rates low for an extended period — that’s a given with a five-year Treasury yield around 0.4 per cent — with the latest economic projections flagging a long recovery process.

Ian Lyngen at BMO Capital Markets says this kind of approach may well test risk sentiment:

“The most relevant question then becomes whether risk assets will be satisfied with such an outcome or scale back, thereby implying that in fact investors are anticipating more from the Fed than is in the offing.”

Plenty suspect the Fed will wait until September before officially entrenching itself deeper within the financial system, through policies of expanding bond buying or announcing a ceiling on Treasury rates via a policy tool known as yield curve control.

Thomas Costerg at Pictet Wealth Management thinks:

“Rather than negative nominal rates, yield caps, as well as potentially more quantitative easing if necessary, are still the Fed’s preferred options.”

Given the Fed’s approach since they began rolling out emergency measures, the likely outcome from their two-day meeting is one of not rocking markets. At this stage of the recovery process, even a hint of letting a market barometer such as the 10-year Treasury yield find a more natural level, will shake risk appetite.

Steve Englander and John Davies at Standard Chartered believe:

“The hawkish risk is that the Fed is insufficiently dovish, and is interpreted as acquiescing to the run-up in rates. We do not see the Fed willing to take that risk. If we are correct, this will probably add to risk buying but cap the recent rise in US Treasury (UST) yields and further weaken the USD.”

The way Fed policy is moving, I certainly look forward to reading their next financial stability report, particularly the section devoted to the dangers posed by excessive debt and leverage.

Source: Economy - ft.com