The beginning of the year for the markets is a stark contrast to the impressive gains of 2017, with a steep fall that was precipitated by arguably the Longest Streak Ever Without a 5% Correction, and also a series of events that have wreaked havoc in the bond market.
Bond investors have recently gained control of the market as a large bond market sell-off threatened the stock market’s historically high valuations. One reason for the sell-off, the value of the US Dollar spiraled perilously downward the first two months of this year, especially against Europe’s Euro, Chinese Renminbi, Japanese YEN. The Fed essentially caved in from continuous pressure from a declining dollar value internationally, especially since the Chinese currency has been considered more stable as of late. An ongoing bond market selloff and potential dollar collapse wasn’t something the Fed wanted to have on it’s watch, and rate hikes were warranted.
EUR/USD Exchange Rate
Trumps Stock Market
With almost a trillion dollars in new debt reaching the balance sheets since Trump took office, his tax cut for the businesses of the country has arguably and ironically simultaneously scared away investors from both the American currency and all of our government’s debt (us10yr, us30yr, us2yr). Continuing on the Republican path of increasing budget deficits, it is becoming more so apparent to investors of our currency and our treasury debt overseas and at home that the government (regardless of party), will continue the exponential and existentially consequential habit of increasing the countries already large debt.
In short, supply and demand took over, and interest rates started peaking upwards to a much feared 3.25% rate as the bond sell-off started. While some believe that the ceiling is already found and rates will start coming down again, others believe that 3.25% is right over the horizon for the United States 30-year treasury bills, and after that upwards again to 4%. It’s important to note that home mortgages are closely tied to the United States 30 Year Treasury Bill, though not directly. When this rate starts going up, everything from mortgages to corporate stocks become increasingly expensive.
As the dollar continued it’s precipitous fall, the Board of Governors of the Federal Reserve in the past 2 weeks had no other choice but defend the dollar by proposing further rate hikes. Unfortunately, the equity markets have not responded very well to the threat, and it seems for the time being, there are at least 3 rate hikes predicted, and possibly even a 4th.
Fed Yellen Exited and the Stock Market Entered
In a weird event that I’m sure will be often be looked over, it’s important to note that the larger stock market correction didn’t officially begin until the day Janet Yellen retired on February 2nd, 2018. Jerome Powell has been perceived to be a hawk (Meaning he is more willing to raise interest rates then not to), not a dove (less willing to raise interest rates Greenspan, Yellen e.g) in monetary concerns, and the Trump administration overall has been more of a hawk as well, fueling speculation among stock market participants that interest rates will soon rise again.
Consequences of Rate Hikes
Each rate hike will make stocks that less profitable to own compared to bonds. Bonds return based on interest rates, while stocks return based on future gains. If future annual returns are 4.5% for stocks for example and only 3% for bonds, it’s obvious that owning equities would be smarter. Stocks are incredibly expensive historically, as I’ve stated earlier, and as bonds become more attractive, these stock investors will run for the exits, lowering the total number of investors in stocks altogether. This has been speculated about for some time and even discussed by Alan Greenspan with his warning to investors of bonds.
It is well known that each interest rate increase will cost the government $200 billion dollars a year just to finance the debt. Also Baby Boomers will need to find a good top to the stock market as they start cashing out of their investments and slowly transition out of high risk equities and into more stable bonds. When interest rates start rising, those bonds will be more attractive to own.
Lastly, noone really knows what the Federal Reserve will do, and predicting whether they will hike rates or not is truly uncertain. Though frankly, it doesn’t look like the Federal Reserve is in control of these interest rates anymore anyway, unfortunately.