While pundits contemplate whether the bitcoin bubble is bigger, smaller or the same size as the dot com bubble, few are willing to admit that day to day events in the equity market are just as ridiculous, bubbly and bizarre as what takes place in the crypto realm. To address this lack of coverage, yesterday Bloomberg was nice enough to publish an article titled "What to Worry About in This Surreal Bull Market" which however only barely touched the surface of just how truly insane capital markets have become, a market which as Citi said last week, even central bankers are worried they have lost control over.
So overnight, as human traders no longer comprehend what is going on in a market dominated by machines and controlled by central bankers, and only know to BTFD, Deutsche Bank's Masao Muraki took it upon himself to explain five of the most prevalent, and confusing, market conundrums.
We present his analysis below in its entirety for the sake of (carbon-based) traders' sanity.
Market upsets: Rationally explaining five conundrums
Change in market tone since September: From 2016 through August 2017, global interest and forex rates and stock prices were strongly influenced by 10y UST yield movements. This led investors globally to focus on US rates. However, since September this simple landscape has changed, creating headaches for bond, forex, and stock market investors. In this report, we highlight five conundrums (questions) and our proposed explanations for them. Rationally explaining recent market moves will be essential to forecasting next year's market.
Our global financial research team's view is that “the current combination of strong economic conditions, low interest rates, low inflation, and narrow credit spreads are supporting a rise in value of risk assets.”, “If the risks (such as difficulties with negotiating a higher US debt ceiling as 8 December approaches) do not materialize, and conditions remain stable (though the path would gradually narrow), then risk asset prices will likely keep rising."
The key focus for 2018 will be the sustainability of low interest-rate/spread/volatility conditions and the Goldilocks market
Five market conundrums
- Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)
- Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)
- Question 3: Ongoing yield-curve flattening
- Question 4: Ongoing decline in interest-rate and stock-price volatility
- Question 5: Ongoing tightening in credit spreads
Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)
90% or more of Japanese stock movements through August were explainable via a multiple regression model using US stock prices and forex. Forex movements could mostly be explained by US interest-rate movements.
Since Japan's 22 October Lower House elections, Japanese stocks including financials have diverged upward from our approximation model. Japanese stocks fell sharply following the 9 November volatility shock, and by 15 November had returned to near our approximation model (Figures 3-4, 20). At that point, we noted that the focus was on whether stocks would revert to the trend implied by our model or diverge again. Recently volatility decreased, and stocks have begun to diverge upward from our model again.
See Figures 4-6. Since September, stock-market volatility has been a major factor behind TOPIX's divergence from our model. This appears to be because some of the funds that flowed into the market during this year's Japan stock rally (from macro hedge funds, CTA etc.) have adjusted risk positions (stock positions) based on implied volatility in option-marke . In our view, the determinants of present Japanese stock-price levels appear to be (1) US stocks (particularly the Dow Average), (2) USD/JPY, and (3) implied volatility of stock prices in US and Japan. We think the third factor in particular should be uppermost in investors' minds, though its sustainability is questionable.
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Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)
Japan and US stock prices continue to rise. This reflects the impact of (1) fundamentals, in the form of strong Jul-Sep results announcements, and (2) a rise in P/E amid the Goldilocks market conditions created by low interest rates and USD weakness.
Obviously, share prices are equivalent to EPS x P/E, and the inverse of P/E is earnings yield. As shown in Figures 7-10, the earnings yield in Japan, the US, and Europe can mostly be explained by the term premium observed in bond-market (the yield premium for long-term bonds due to price fluctuation and illiquidity risk) and the risk neutral rate (average forecast short-term interest rate over the next 10 years).
A one standard deviation decline in term premium causes stock prices to rise 2.5% in the US, 1% in Europe, and 5% in Japan. A one standard deviation increase in forecast short-term rate results in increases of 2%, 2.75%, and 7.8%. The recent decline in term premiums have led to a rise in P/E via a decline in risk-free rate and equity risk premium.
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Question 3: Ongoing yield-curve flattening
Flattening European and US yield curves are a source of frustration for investors who had forecast steepening. Fed fund rate hikes amid structurally low interest rate conditions have (1) raised the average forecast short-term rate, but (2) have conversely lowered the term premium (Figure 11-12). Dominic Konstam from our Rates Strategy team estimates 2.25% as the fair end-2017 level for 10y yield.
Francis Yared from our Rates Strategy team sees US tax reforms as the main driver over the next 2-3 months. Our base scenario is for the passage of a mid-sized tax cut (increasing the fiscal deficit by $1.5trn) in early 2018. We expect long-term rates to rise due to the above factor and above-trend US economic growth. Matthew Luzetti from our US Economics research team estimates a neutral real short-term rate (neutral for economy) of 0.3% and a neutral real 10-year rate of around 1.5% (Figure 13). If we assume the Fed achieves its 2% inflation target, this would imply a neutral nominal 10-year rate of around 3.5%, suggesting ample room for long-term rates to rise.
Peter Hooper from our US Economics research team, does not expect the change in Fed Chair to have a significant impact on monetary policy. Chair-designate Powell is likely to be strongly opposed to the Taylor Rule or other limitations on Fed behavior. Powell lacks the specialist economic and monetary policy knowledge of previous Fed Chairs, but has front-line financial and capital market experience. He may also be more receptive to arguments about a structural decline in inflation than Chair Yellen. However, it is unclear whether he would continue to support an approach that combines a regulatory and supervisory response to monetary disequilibrium (excessive risk-taking) and monetary policy to optimize inflation and employment. Also, his biggest point of difference with Yellen is likely his stance on deregulation for largest banks.
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Question 4: Ongoing decline in interest-rate and stock-price volatility
As shown in Figure 17, interest rate and stock-price volatility are both at all-time lows.
In Figures 15-16, US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding. In our view, this model suggests that the fall in interest-rate volatility was led by (1) a decline in general investors' ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.
In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types) (Figure 19), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.
While we recognize the structural factors that are depressing volatility, we are also concerned about the risk of a sudden spike. We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility (Figure 17). There is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.
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Question 5: Ongoing tightening in credit spreads
Since late October, widening corporate bond and CDS credit spreads (Figures 28-29) have been a subject of market debate. This trend has recently receded due to an excess liquidity and investors' search for yield.
The default rate (Figure 30) clearly shows that the corporate credit cycle reversed. The recovery in energy prices and stiffer competition for bank lending (relaxed lending conditions) are supporting a turnaround in bad corporate loans and credit costs. The SLOOS data released on 6 November showed that banks' lending stance has eased (Figures 33-35).
Nevertheless, corporate debt levels remain high. There are signs in areas such as subprime auto loans, credit-card loans, and CRE (commercial real estate collateral) loans that credit and economic growth may be nearing an end.