The Trend Is Your Friend ... Until It’s Not: John Authers

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A Very, Very Big Deal

The last week might well go down in market history. Just to re-cap, central banks across the planet hiked rates aggressively, often by more than expected, and often with promises that more tightening was in the pipeline. In response, bond yields shot up, and equities sank to new lows for the year (outside the US), a fate that the S&P 500 only escaped with the aid of a dramatic late bounce on Friday afternoon. This is important stuff, bringing the economy into territory that few people much under 60 can even remember, at least during their working lives.

The question now is whether despite all of this, we might be overdoing it. To be clear, the selloff is very painful. The 60/40 equities/bonds strategy, which has worked reliably for years, hit a new low for 2022 at the end of the week. It is now in its most prolonged drawdown since the Global Financial Crisis of 2007-11:

And on any sensible basis, the US dollar is very, very strong. That has some benefits for the US in its fight against inflation but it makes life much harder and less predictable for everyone else, particularly in the emerging markets:

Further, this can no longer be dismissed as merely knocking away the froth from the speculative excess that followed all the free money distributed during the pandemic. The following chart shows the NYSE Fang+ Index of the biggest internet platform companies relative to the equal-weighted version of the S&P 500. Both grew wildly over-extended, and both started falling sharply relative to the average stock early last year. For the last several months, however, Ark Innovation ETF and the Fang+ index have been trading bang in line with the S&P 500 Equal Weight Index. This is no longer about getting rid of speculation.

So there’s no question that something very significant is afoot for the financial world. The question is whether we are getting over-excited or falling victim to the propensity toward extrapolating trends infinitely. Journalists know all about this, as it manifests itself in the so-called “Cover Curse” — once a trend is so clear that magazine editors have put it on the cover, it tends already to have reached its zenith. A Businessweek cover from 1981 proclaiming the “Death of Equities” a few months before the beginning of the longest equity bull market in history is the most famous of the genre. But more recently, this is The Economist cover from late 2011, when the world economy was — with hindsight — beginning a recovery:

And then there is this cover from my colleagues at Bloomberg Businessweek, from April 2019. The timing wasn’t perfect, but it certainly hasn’t aged well:

So, have we in the media succumbed to journalistic over-excitement once more? Peter Atwater of Financial Insyghts LLC, who monitors market mood and kindly provided the magazine covers above, thinks the degree of absolute certainty in much coverage suggests a rebound is probably coming. This includes my own. Commenting on the last Points of Return for last week, which confidently predicted that “The Trend Is At An End” for bond yields, he said:

While I suspect John is accurate in his assessment, widespread absolute certainty matters. Put simply, we now appear to be moments away from a “shocking” reversal in bond yields – which is likely to be paired with a similarly surprising reversal in the US dollar, as well as a remarkable (and currently laughable) turn of fate for the British Pound.

For another example of certainty (also from Bloomberg because I don’t want to appear to be criticizing competitors, but you could do this exercise for the entire financial media), Atwater suggests this one:

Atwater isn’t accusing journalists of being idiots (I think), or of being irresponsible. His point is that headlines like this show that we’ve done our job in pointing out that a trend now seems irreversible and unassailable. And it’s at such moments that investors, and markets, can find themselves stepping on a rake.

Consumers vs. Bond Markets

For one key trend that doesn’t fit the prevailing narrative, look at consumer confidence in the US. Even if multiple negative catalysts threaten companies ahead, plenty of stock market bulls still believe in the strength of the consumer. And consumers don’t seem to have received the bond market’s message. This is how the University of Michigan’s widely followed consumer sentiment index has moved:

Evidently, and unsurprisingly, confidence is much lower than it was before the pandemic. But in markets it’s moves at the margin that matter, and the resurgence of optimism over the last three months, albeit from a low base, has been remarkable. Here is the rolling 3-month change in the sentiment index, showing that the last quarter has seen the biggest boost in sentiment in more than a decade:

How is that possible? Look no further than the oil price. By the end of last week, crude oil contracts had dropped below their level on the eve of the Ukraine invasion. That delivered a huge reduction in the price of gas at the pump, as measured by the American Automobile Association. Yes, gas prices are still higher than they were at the beginning of the year, but a fall like this will make motorists feel much better:

I suspect this has much, if not everything, to do with the improvement in mood. Americans love the motor car. Low taxes on gasoline mean that rises in crude prices translate swiftly into big percentage increases at the pump. And gas prices appear in big numbers on signs posted on the side of the road. Everyone is conscious of the way the price moves in real time. They’re also wont to pay the money they don’t have to spend on gasoline on something else.

The rising gas price was bad for the Federal Reserve because it raised inflation. But the falling gas price, by stimulating extra consumption at a point when the Fed wants to engineer a slowdown, also promises to be a problem. It’s also threatening many political calculations by reviving the fortunes of President Joe Biden, who appeared to be beyond hope only a few months ago.

The oil market may yet have another turn in it. Its power should not be underestimated. And neither should the enduring optimism and power of the US consumer.

— Isabelle Lee

A British Landmark in the Dead of Night

As London slept, traders in the pound sterling administered a huge blow to national pride in Asian hours. Britain’s currency briefly took out an all-time low against the dollar that had stood since early 1985, when Margaret Thatcher was prime minister. The record was $1.0545; early trades, on thin liquidity, brought it down as far as $1.0350 before it caught a bid. At the time of writing, the pound is just over $1.05. But the milestone has still been passed.

This is how the pound found its way to that new low, after a week which started amid the calm of the Queen’s funeral. Ringed in the chart are the times of the Federal Open Market Committee meeting on Wednesday, the Bank of England’s Monetary Policy Committee announcement the following day, and new UK Chancellor of the Exchequer Kwasi Kwarteng’s “mini-budget” speech on Friday morning. This last spectacular leg down for the pound cannot be attributed to the central banks:

(Before going on, it’s worth a side note to dismiss the contention of some British politicians that this fall is down to the Bank of England, which opted to hike rates by only 50 basis points, after the Fed had hiked by 75 basis points the day before. All else equal, this would indeed tend to weaken the pound — but note that the one major currency that slightly underperformed sterling last week, was the Swedish krona, and that this happened even though the Riksbank had opted for a 100 basis-point hike. Kwarteng’s speech unleashed the sterling bears.)

The effect has been to drive up expectations for future BOE rate hikes. This chart shows Bloomberg’s measure of the expected bank rates that would prevail after the MPC’s November and December meetings. The shift upwards is dramatic:

The same picture applies to the longer term. This is the implicit expectation for the bank rate from now until next August’s meeting, as it stood in June, on Thursday of last week, and on Friday after the Kwarteng speech. Investors are now bracing for rates to be much higher for much longer:

How big of a deal is the currency reaction? Friday’s trading saw the fourth-biggest fall for the pound against the dollar in the last four decades. The only three worse days came in the first Covid lockdown of 2020; the “Black Wednesday” exit from the exchange rate mechanism of the European Monetary System in 1992, and the Brexit referendum in 2016. It’s possible that this was an overreaction, but it was undoubtedly a historically big reaction:

(At its worst, the sell-off in the Monday small hours was 4.7%, overtaking Black Wednesday for second place, but it has since recouped much of that damage.)

What exactly was so damaging about Kwarteng’s budget? The big news was that he was cutting taxes in a huge way. The top rate of 45% was abolished altogether, while the standard rate was cut from 20% to 19%, and the “stamp duty” payable on housing transactions was reduced. He also reversed various tax rises that were due to come into effect. Adding it together, it was the biggest proportionate cut in tax since the budget of the Conservative chancellor Anthony Barber in 1972. It also bears close similarity to another famous budget by another Conservative chancellor, Nigel Lawson, in 1988. On that occasion, Lawson made a massive reform of the then very progressive tax structures, abolishing higher tax bands of 45%, 50%, 55% and 60% in favor of a single top rate of 40%.

So this is the third great Conservative tax-cutting budget of the last half-century. If we look at the BOE’s main target rate over that time, you can easily see what happened to monetary policy in the wake of the first two:

Both times the BOE (not then independent and ultimately controlled by the chancellor) had to swiftly embark on massive rate hikes. The “Barber Boom” is now popularly blamed for the inflation and debt crises that plagued the UK for the rest of the 1970s, while the Lawson budget led to UK inflation above 10% and a recession in the early 1990s. Releasing a lot of money into the economy in a hurry will create a shock that needs to be controlled by monetary policy. Financial markets therefore think that current UK interest rates are bound to have to rise, and consequently they have bid up 2-year gilt yields in an extraordinary way. At the beginning of last year they were negative; last month they were below 2%; now they’re touching 4%:

There are some bizarre suggestions in the UK press that the market reaction is fueled by anger about inequality. They are nonsense. Currency and bond traders tend not to be passionate, ideologically-driven egalitarians. They generally agree with the new British government that wealth needs to be created before it can be redistributed.

But egalitarianism does color the market reaction for two reasons:

1. It was an active choice to structure these tax cuts in a way that was so much more beneficial to the better off than to everyone else. The Barber tax cut of 1972 was achieved almost entirely by raising thresholds before tax was payable; the total cut to tax revenue was GBP 1.2 billion, of which GBP 960 million came from raising allowances. The Lawson budget also involved raising allowances and closing loopholes that made it easier to get mortgage tax relief, so again it was less regressive. The UK levies plenty of indirect taxes on people when they buy rather than when they earn, and reducing those would have been less regressive while still providing a fiscal boost. So the way this budget stokes inequality was not inevitable, and will probably look like a dangerous judgement to many investors because of the second factor;

• 2. Inequality is high on the political agenda at present, and the current Conservative government won the 2019 election under Boris Johnson largely by convincing a swathe of traditionally Labour-voting working class people in the north of England that the Conservatives would help them by “levelling up.” The Brexit vote itself was intended as a step to reclaim control from elites. Announcing a tax package in this context looks almost like a declaration of class war. Currency traders may not mind that too much, but they definitely do mind that this is a dangerous step that could destabilize the government. This looks like terrible politics (particularly when the decision to remove the cap on bankers’ bonuses is thrown in) because it is. The markets don’t like that;

• 3. Classic economic theory suggests that poorer people are more likely to spend any money that comes their way. Thus if the aim of the tax cuts is to stimulate the economy, it makes sense to skew them toward people with lower incomes. That didn’t happen.

Beyond that, there are issues of ability to repay. These do not usually afflict developed economies like the UK, but it did once (in 1976) have the experience of going to the International Monetary Fund for a loan. The combination of sharply rising bond yields and a sharply falling currency is very unusual outside emerging markets, and implies doubts over the government’s ability to service its debt. This seems overdone. Indeed it’s extraordinary that markets, driven by people who want to make a profit rather than a loss, are this negative. But the loss of confidence in the UK under its new leaders is real, and will have real world effects unless the British authorities can do something imminently to regain trust.

Is the record low against the dollar an example of “cover curse” type thinking? It would certainly be dangerous to extrapolate a falling pound infinitely into the future. It will find a level. There is no currency peg to defend. And the concentration on the dollar, which is historically strong, does make the problem look worse. Against the euro, and against a trade-weighted basket of currencies, this selloff is drastic but the lows set during Covid remain intact. The eurozone also has some serious problems of its own:

So it’s possible to exaggerate sterling’s fall from grace. However, market judgments can drive their own reality — a concept that George Soros, famous for his impact on the pound, has labeled “reflexivity.” Loss of confidence on this scale is damaging.

The logic behind the Kwarteng budget, to the extent that I can find any, rests almost on a gambler’s calculation. The Conservatives are likely to lose the election in 2024; their best chance to win is to go all-out to stoke growth now, and hope it delivers well enough to win in 2024. If the gambit fails, the Conservatives were going to lose anyway. Responsible management wouldn’t deliver victory in 2024. Utter recklessness just might.

The currency market seems to find the UK’s new fiscal policy as reckless as I do.

Survival Tips

Just as the markets meet what could be an epochal turning point, it’s time for the new year — at least according to the Jewish calendar. Today is the first day of Rosh Hashanah, when Jews celebrate the anniversary of the world’s creation. Very few people believe that it’s possible to put a date on the beginning of the world any more, but it’s a powerful and a moving opportunity to take stock of life and aim for renewal. It’s also an excuse for some great if ludicrous a capella singing. There’s Rosh Hashanah in the style of One Direction for instance, or OneRepublic (with a video set on location in my home neighborhood of Washington Heights). And for those unsure how to pronounce Rosh Hashanah, the stresses fall on the same syllables as My Sharonah by The Knack.

Have a good week everyone, and Shana Tovah to those for whom this is a new year.

More From Bloomberg Opinion:

• Julian Lee: Oil Markets Are Volatile But They’re Not Broken

• Chris Hughes: Get Ready for the Great British Fire Sale

• Robert Burgess: The Strong Dollar Is About to Pay Some Dividends

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To contact the author of this story:
John Authers at jauthers@bloomberg.net

To contact the editor responsible for this story:
Andreea Papuc at apapuc1@bloomberg.net

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