(Bloomberg Opinion) -- President Donald Trump came out late Tuesday and said the Federal Reserve’s once-per-quarter pace of interest-rate increases was too fast. “I like low interest rates,” Trump said. He doubled down late Wednesday, saying the Fed “has gone crazy.” Putting aside all the reasons why it’s a bad idea for a sitting president to comment on monetary policy, perhaps he’s right. At least that’s how financial markets seem to be behaving, with the S&P 500 Index tumbling to its lowest since July and benchmark 10-year Treasury note yields reaching their highest since 2011.
Equities and bonds have been under pressure ever since the Fed raised rates on Sept. 26 for the third time this year and the seventh time since Trump was elected. In subsequent speeches, policy makers made clear they are leaning toward raising rates above what is considered neutral, which is a level that neither stimulates nor restricts economic growth. Where that is, nobody knows for sure, but as Fed Chairman Jerome Powell said last week, “we’re a long way from neutral.” So it’s hardly surprising that bond yields across the curve have shifted higher. That’s important for equities because the current bull market, which began in March 2009 and is now the second-longest in history, has largely been the result of low borrowing costs brought on by rates that the Fed deemed “accommodative” until Sept. 26. What has traders spooked is that the Fed seems to be brushing off signs of a global economic slowdown and a rapidly escalating trade war between the U.S. and China — the world’s two largest economies. Also, the Fed seems intent on wringing out some of the excesses that have built up in markets. “A very-low interest-rate environment for a long time does, at least in some dimension, probably add to financial risks, or risk-taking, reach for yield, things like that,” Federal Reserve Bank of New York President John Williams said Wednesday. “Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.”
Higher rates in and of themselves aren’t bad for financial markets. The S&P 500 Index is up some 40 percent since Fed began lifting its target for the federal funds rate from near zero in December 2015, while the Bloomberg Barclays U.S. Aggregate Bond Index has gained 3.61 percent. Still, the Fed has a reputation of raising interest rates until “something breaks.” The markets are beginning to think that this time may be no different.
FEAR GAUGE FLASHES WARNINGTo be sure, plenty of things are weighing on investor sentiment besides the Fed. Rising trade tensions between the U.S. and China, signs that China's economy is slowing rapidly, a potential Italian debt crisis, a slowdown in corporate earnings growth, rising oil prices, a soon-to-be $1 trillion U.S. budget deficit and distress in emerging markets are but a few of the dark clouds hanging over markets. What’s evident is that traders don’t see things clearing soon, judging by measures of volatility. The CBOE Volatility Index, or VIX, which is nicknamed the “fear gauge,” shot up Wednesday by the most since June to its highest since early April. Not only are traders paying more for front-month VIX futures contracts relative to the second-month contract, but the premium is biggest since April, according to Bloomberg News’s Ye Xie. What makes the current situation unusual is that the VIX curve typically slopes upward, with longer-dated contracts trading at a premium to shorter-dated ones. That’s because the outlook for U.S. equities is more uncertain over longer periods. Put another way, traders are concerned about the near-term outlook for equities. But there is a silver lining: Wednesday’s high of 23 was far below the 50 mark reached during the late January/early February correction in stocks.
BOND SENTIMENT WORSENSHow negative has sentiment become toward bonds? Consider that on a day when Treasuries should have been in high demand given what happened in equities, they weren’t. The Treasury Department’s monthly auction of three-year notes drew bids for 2.56 times the $36 billion offered, the second-lowest bid-to-cover ratio going back to 2009. That’s despite yields being at their highest in 11 years. The 10-year note auction didn’t do much better, generating the second-lowest bid-to-cover ratio of the year for that maturity. This suggest there’s something else spooking bond investors than just a hawkish Fed. Perhaps it’s no coincidence that the pushback comes a month before the midterm elections, which is unlikely to produce a favorable outcome for bond investors no matter which party gains control of the House and Senate. As Bloomberg News’s Liz McCormick points out, if Democrats take the House, it raises the odds that congressional leaders will propose an infrastructure-spending bill similar in scope to Trump’s original trillion-dollar proposal. And if the GOP defies expectations and maintains control, tax cut 2.0 becomes more likely. In either case, the result is likely to be an increase in the supply of debt. “The issues with Treasuries remain and are not now a flight to safety,” Bleakley Financial Group chief investment officer Peter Boockvar wrote in a note to clients Wednesday.
7 IS THE SCARIEST NUMBERBeyond the Fed, the biggest concern in markets has to be China. The economic data have pointed to a slowdown in growth, suggesting U.S. tariffs against Chinese goods are starting to bite. As such, China has allowed its yuan to slowly weaken, from 6.2431 to the dollar in March to 6.9242 on Wednesday. Now there are signs that China may allow the yuan to weaken past 7 to the dollar, a key psychological level it hasn’t breached in a decade. Bloomberg News’s Emma Dai and Tian Chen report that former central bank adviser Yu Yongding wrote in a China Securities Journal commentary that tolerance of yuan weakness is needed for exchange-rate reform. “Yu’s commentary is likely part of China’s efforts to shape expectation and prepare for the yuan to breach 7 per dollar, so that the market wouldn’t panic when it happens,” said Xia Le, the Hong Kong-based chief Asia economist at Banco Bilbao Vizcaya Argentaria SA. The worry is that while such a level might aid China’s exporters and counter U.S. tariffs, it might also spark a flight of capital from the country that the authorities won’t be able to stem, throwing the global financial system into a new crisis. The alternative is for China to use up even more of its foreign-exchange reserves to support the yuan. “There is no dramatization in suggesting that whatever Beijing does, its ramifications will be felt far and wide,” Neil Mellor, a senior currency strategist at BNY Mellon, wrote in a research note Wednesday.
MICHAEL SPARES OILIt wasn’t all bad news for markets on Wednesday. That’s because oil prices fell as much as 2.75 percent in the biggest drop since mid-August amid speculation Hurricane Michael will be less of a threat to the supply of crude and more to fuel demand. While Hurricane Michael was expected to be the strongest storm to hit the U.S. in 14 years, its track took it to the east of offshore oil and gas platforms, according to Bloomberg News’s Samuel Robinson. Mizuho Securities estimates that fuel demand may fall by as much as 1 million barrels a day. Meanwhile, U.S crude inventories are likely to increase 2.5 million barrels this week based on a Bloomberg survey. Markets have been worried that the rise in oil prices the last two months might eat into corporate profit margins and weigh on consumer spending. Michael has curtailed offshore oil production in the Gulf by 40 percent. However, because the region produces only about 17 percent of U.S. crude, down from 32 percent in 2009, the market ripples are smaller when platforms are shut while the storm passes. Fuel demand may decline as drivers in the southeast U.S. stay off the roads as the storm passes through. Gasoline futures fell 1.6 percent, and its premium to crude futures narrowed.
TEA LEAVESGiven all that has been happening in markets, Thursday brings perhaps the most anticipated inflation report in recent memory. A strong increase in the core consumer price index, which excludes food and energy, will only add to concern that the Fed will keep raising rates steadily for the foreseeable future. A weak report might have the opposite effect. But don’t expect any great insights from economists on what is likely to happen. That’s because the median estimate among economist surveyed by Bloomberg is for an increase of 0.2 percent in the number for September — the same estimate they have had every months going back to 2015. To be fair, that’s not really an indictment of economists. Instead, it speaks to the stable nature of inflation in recent years, which has allowed the Fed to raise rates gradually without any surprises.
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Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis.
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