Four financial questions for Passover
A time for reflection on why the market does not make sense
John Authers
Traders at the CBOE in Chicago monitor a sudden rise in volatility that alarmed markets in February © FT montage; Getty Images
A holy junction has arrived. As I write, the world’s Christians are ready to commemorate Good Friday, the day when Jesus gave his life on the cross, while Jews prepare for Passover, the festival that commemorates their exodus from Egypt. It is an ideal moment for reflection.
Jesus’ Last Supper was a Passover feast, known as a seder, full of rituals and symbols to commemorate the exodus. At the beginning, the youngest person present must ask four questions, to explain why a seder is different from all other meals. In a far more recent tradition, the Long View each year asks four questions about why the market does not make sense. So here are this year’s four financial questions for Passover:
1. Why are Treasury yields falling again, when only a matter of weeks ago they appeared to have conclusively moved into the long-dreaded secular bear market?
The argument for a secular bear market — with falling bond prices and hence rising yields — seems clear. The US economy is strong, and for several months there has been a synchronised global recovery. That should mean higher inflation in the long run, and higher bond yields to compensate for it. One huge extra force pushing down on bond yields, of course, has come from central banks. Low interest rates, plus deliberate actions to buy bonds and hence raise their price and reduce their yields, have sustained the bull market that started in the early 1980s.
Those actions are now being reversed in the US, as the new Fed governor made clear this month, while Uncle Sam is selling more new bonds to finance the US deficit, which is growing after the tax cut. Higher supply plus lower demand should mean a lower price and higher yields.
Finally, there is the issue of trend — bond yields had been locked in a steady downward trend, which was the most reliable in world markets. In the last week of January, just before volatility hit the equity market, that trend was broken when the yield surpassed 2.68 per cent. That was supposed to herald a swift rise to 3 per cent and beyond. So why has the 10-year yield instead dropped back to 2.74 per cent?
In part the “structural” factors that have been pushing down on yields remain strong. Insurers need to buy bonds for regulatory reasons; yields are far lower elsewhere so this creates demand to buy US bonds, thus depressing their yields; and demographic trends, with ageing populations, also tend to boost buying of bonds. We will now find out how strong those forces are.
In the short term there are two other factors. First, very many people were happy that yields were rising. It was a consensus trade, if not an overcrowded one, and they are now being punished. Second, and more important, macroeconomic data have looked less impressive of late, particularly in Europe, while inflation is failing to rise as many had expected. If the world is still not emerging into a stronger growth trend, then there is less need for yields to rise — and a lot of other calculations will go awry.
2. Why are stock markets so volatile when for years they had been as calm as they have ever been?
US stocks suffered their first negative quarter since 2015. This happened despite great earnings results, and continuing strong macroeconomic numbers, as the corporate tax cut agreed at the end of 2017 came into effect. In January, stocks went into a pronounced tear, egged on by celebratory tweets from the president of the US, and appeared to be melting up. By the end of the quarter, the main US indices were down, as were all the main world indices. What happened?
Initially, stocks sold off because of some worrying inflation data, which helped to push up bond yields (which in turn meant there was less support for equity valuations). But as we have just seen, the moves upwards in inflation and in bond yields are now called into question, and yet stocks are still down for the year.
The business models of the Faang stocks (Facebook, Apple, Amazon, Netflix, Google), which had led the market for more than a year, have been called into question. This has damaged sentiment. But again, the NYSE Fang+ index remains up for the year. If we are really going to reappraise the stocks that have been leading the market, there is much further to go.
Maybe, just maybe, it’s the Trump effect. The tax cut has been achieved. We are no longer so sure that his remaining ideas are so good, and most investors think his ideas about trade are downright terrible. And so the market has started reacting to presidential tweets. For more than a year, it had comfortably ignored them.
Most importantly, though, key assumptions have been stripped away. We can no longer rely on low volatility. And critically, the positive view of a low-inflation strong-growth future has been called into question — but only after the stock market had priced in that assumption as a done deal. Let us hope that that assumption does not turn out to be downright wrong.
3. Why is the dollar weakening when at all other times the high yields on Treasury bonds would pull money into the US?
Generally, money flows where it can make the highest interest rate. And yields on US bonds have recently exceeded those available on European bonds by 2.3 percentage points; five years ago, this figure was barely 0.5 percentage points. This should attract money to the US, and push up the dollar, and yet the opposite is happening, with the dollar dropping more than 2 per cent against a trade-weighted basket of currencies in the first quarter. Why?
There are a few simple explanations. First, the oil price is rising. Oil transactions are denominated in dollars, so as oil rises, sellers are left more with dollars (“petro-dollars”) that need to be sold; over history there is a clear inverse relationship between oil prices and the dollar. And more generally, economic growth and confidence tends to mean a weaker dollar, because this reduces demand for US assets as a “safe haven”.
But this does not quite work. Of late, bond and stock markets have shown a sharp attack of nerves about growth, and the dollar has stayed weak. Again, the easy answer many tend to offer comes from the political row of the moment: the US is threatening trade tariffs, the president has talked openly of winning a trade war, and this might be scaring potential investors away from the dollar. A trade war still looks unlikely — a return to 1930s-style tariffs walls is not in anyone’s interests. So this implies that more dollar strength could be in the offing, but it also suggests that markets really are nervous about trade tensión.
4. Why is inflation still so low everywhere when unemployment appears to have been beaten in the US, and is falling almost everywhere else?
The economic debate over the “Phillips Curve” has riven academic economics for decades and now it is dividing opinion in capital markets. Low unemployment should mean higher bargaining power for workers, hence higher wage inflation, and hence higher price inflation. In the US in the last week before Easter, fewer people signed on as jobless than in any week since 1969, while unemployment rates have dived across the rest of the world. And yet inflation is supine: the PCE deflator, the Fed’s preferred measure, came in at 1.8 per cent, safely below the 2 per cent target.
One explanation is that there is an overhang of workers who do not appear in the unemployment figures because they are not making themselves available for work. If this is voluntary, then as prospects improve, they will steadily return to work and wages will not inflate as expected. If it turns out that the people not making themselves available for work are, in fact, unemployable, as they lack the skills for the modern economy, then wage inflation is more plausible.
Another explanation is that the relationship between unemployment and inflation is not all that strong. That would imply that the long era of low rates, low inflation and unimpressive growth can continue. And as so many have been allocating their money on the assumption that that era is over, it could lead to some very difficult times on markets.
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