Stocks rose sharply in the first days of November due to the sharp drop in interest rates, but the rebound … [+]
Statistically speaking, the fourth quarter is good for the stock market. The average and median S&P 500 returns for this period are by far the highest, as are the chances of them increasing by any amount. As with all things stock, of course, such history is no guarantee, and the S&P 500’s -2.2% decline in October hasn’t gotten it off to a good start.
The fourth quarter has the highest median and average return in the S&P 500, and it is the … [+]
But what a change a week can bring. November got off to a hot start, which observers attribute to a less hawkish message from Fed Chairman Jerome Powell, which is notable because it wasn’t. Be the judge:
- “Economic activity expanded at a strong pace in the third quarter” (in September he said the economy had been growing “at a solid pace”).
- “The process of bringing inflation sustainably to 2% has a long way to go. »
- “The committee is not considering rate cuts at all at this time. We are not talking about rate cuts.”
- “The idea that it would be difficult to restart after stopping for a meeting or two is simply not fair. The Committee will always do what it deems appropriate at the time.
- “We will need a slowdown in growth and some slowing in the labor market to fully restore price stability. »
Regardless, the market heard what it wanted to hear and took off when the 10-year Treasury yield fell half a percentage point after rising sharply from 4% in August to 5% at the end of October. This is actually the main reason why stocks are rising. As such, stocks remain highly dependent on the future movement of long-term interest rates. And it is not certain that they have already reached their maximum.
This is a problem for several reasons. For starters, higher long-term rates make consumer debt very expensive, and indeed, rates on mortgages, auto loans and credit cards are at multi-decade highs. Unsurprisingly, unpaid debts are too. Businesses are also suffering, as the prime rate on commercial bank loans is now at its highest level in more than 20 years. A higher cost of capital affects companies’ bottom lines and, beyond a certain level, could even impact companies’ ability to refinance existing debt, leading to defaults.
Consumer and business interest rates have reached multi-decade highs, but their economic impact is not yet visible. … [+]
The other problem with high long-term interest rates is that they impact stock valuations. In general, higher rates put downward pressure on price-to-earnings (P/E) ratios. This means that for prices (P) to remain stable, profits (E) must increase. But income is a function of overall economic activity, and higher interest rates tend to constrain the economy rather than stimulate it.
Even though long-term rates fell during the first days of November, there could be several reasons why they are starting to rise again. The Federal Reserve may be done with rate hikes, but it only controls very short-term rates. Long-term rates are determined by market forces, which depend on factors largely beyond the Fed’s control, such as foreign purchases, geopolitical events and the amount of debt outstanding at each maturity. It is far from certain that long-term rates have peaked.
One factor is that they remain below rates below 6 months. This is not a lasting condition. Normally, there should be a risk premium attached to lending money over longer periods (the longer the term, the higher the chance of things going wrong for the borrower), unless the lender believes that for some reason rates may fall in the future, so the borrowing rate locked in today will be higher than market rates in the future and will compensate for time risk additional.
Since this inverted relationship is an anomaly, it usually disappears after a while. It has already lasted 15 months, and its end seems near. Since the Fed is adamant about not cutting short-term rates in the near future, normalization can only happen if long-term rates rise.
The U.S. Treasury’s decision to finance the growing U.S. budget deficit with short-term debt, thereby flooding the market with Treasuries, pushing Treasury yields to the highest levels along the entire yield curve , contributes to this inverted curve. It is not clear why the Treasury chose to do this.
The US Treasury played an important role in the inversion of the curve, as it flooded the market with … [+]
One explanation could be that the Treasury does not expect high rates to persist and is therefore reluctant to keep rates high for longer than necessary. Another, more likely explanation is that buyers have much more appetite for Treasuries and money market funds (which invest in Treasuries) than for longer-dated bonds, so it is the easiest way to raise a lot of money. The recently announced funding schedules have more similarities, which the market welcomed after concerns that long-term issuance would continue to drive up long-term rates. Confirmation that the focus remained on Treasury issuance helped push long-term rates lower and benefited stocks.
It seems reasonable to say that the stock market rally in the first week of November has little to do with the outlook for earnings or the economy, and a lot to do with the sharp decline in long-term rates. But it’s not enough. Long-term rates will fall further if the economy enters a recession, in which case stocks will fall. Investors should therefore view the enthusiasm that followed Fed Chairman Powell’s comments with great caution. The final quarter may end on a high note, as it usually does, but beyond that, the future still looks bleak.