MARKET TURMOIL AHEAD? / MACLEOD FINANCE

Market turmoil ahead?

US equity markets seem ripe for a significant pullback, or even a severe bear market, with bond yields unlikely to fall much before rising again. If so, how will it play out for gold?

Alasdair Macleod

The Fed’s 50 basis point cut in its fund rate was more than expected, other than by optimistic equity bulls. 

But realistically, it means that in the absence of solid statistical information that the US economy is entering a slump, there are unlikely to be further significant cuts in the foreseeable future. 

Additionally, there are signs that US Treasury yields along the curve are unlikely to fall much from recent lows and could even be turning higher. 

This would be consistent with a growing funding crisis, which so far has not tested demand for longer maturities other than from US pension funds.

Consequently, the US Government’s debt profile has been shortening. 

It is not for nothing that the Treasury has been paying higher rates by issuing T-bills of up to one-year maturity. 

The cut in the Fed’s rates lowers T-bill discount rates, and perhaps that was an objective. 

But it confirms that not taking advantage of lower yield maturities out along the yield curve for funding makes them artificial, temporarily suppressed by minimal debt funding supply. 

Whatever the short-term outlook for them, they should be higher.

The biggest myth in markets is that inflation is diminishing as a problem and that the outlook for interest rates is therefore to continue falling. 

This belief is fuelled by relatively recent experience, whereby suppressed rates persisted seemingly without inflationary consequences for a prolonged period. 

Furthermore, bond market bulls grab every piece of statistical evidence to interpret a risk of recession unless rates are lowered.

However, by cutting the funds rate by 0.5% the Fed has signalled it has demoted inflation’s priority, even abandoning it in favour of sustaining economic activity, and keeping the equity bubble from deflating. 

Market responses were immediate, with gold, oil, copper, and many other commodities soaring. 

The chart below from Finviz.com shows how commodities have risen priced in dollars in only the last week. 

When almost the entire commodity complex shifts to higher dollar prices, read correctly it is a decline in the dollar’s purchasing power for commodities.

There are two simple reasons why current establishment views are dangerously complacent. 

The first is that inflation is not going away, being fuelled by continuing budget deficits and the drawdown on savings. 

Rather than a post-2000 comparison of subdued inflation a repeat of the 1970s inflationary tendencies beckons. 

US Treasury yields at that time hit highs of 15% as the value of credit (i.e. US dollars) declined against gold, which was and still is real money. 

And the second reason is that irrespective of the inflation problem, there is a long-term rejection of the dollar because of the debt trap the US Government finds itself in, and also for geopolitical reasons as the governments of the majority of the world’s population are tired of US dollar hegemony.

The convergence of these negative factors is reflected in the end of the long-term decline in bond yields illustrated in the chart below.

The long-term downtrend with multiple touch points was well and truly broken in mid-2022, and the reaction from a high of 5% a year ago to 3.62% last week (3.74% currently) is a normal consolidating pause in the underlying uptrend.

The problem for equities is that valuations relative to bond yields are already stretched to eye-watering levels, only justified if there is a substantial fall in bond yields which on the evidence will not happen. 

This valuation disparity is illustrated in our next chart.

To illustrate the valuation disparity between bond yields and equities I have inverted the line representing the bond yield. 

By basing both data lines at 100 in January 1985, I have been able to illustrate the relationship of a tight negative trend correlation. 

The notable exceptions were in 2000—2002 when the dot-com bubble drove equities to exceptionally high valuations, the covid distortion of 2020 when the Fed reduced the funds rate to zero, and today illustrated by the double-arrowed line. 

It should be noted that the excess valuation of the S&P 500 index is about twice as extreme as during the dot-com bubble.

There can be no reasonable doubt that with the bond yield unlikely to fall significantly that US equities are vulnerable to a major reversal, and that to the extent other national equity markets are influenced by US market developments they will be as well.