The S&P 500 struggled this week though not as badly as hyped. The S&P 500 started the week at 2,832 and finished near where it started at 2,800 by Friday’s trading close. Initially things looked positive to start the week, as the markets rallied to 2,854 by Thursday before the 2% drop on Friday.
Most of the commentary stemmed from yield curve inversion whereby shorter-duration bonds traded at higher interest rates than longer duration 5 and 10-year bonds. Generally speaking, the markets knew this event would trigger at some point during this year, but when looking at the other data points tied to the economy there’s not much that would indicate an immediate recession looming over the horizon.
Some have speculated that with the inversion of the yield curve the stock market is on course for a major price correction. However, there’s usually a lag between the peak of an economic cycle and when the yield curve inverts, so it’s not a definitive signal of a peak in equity prices.
We would need to confirm the inversion of the yield curve for a sustained timeframe, and earnings season would have to be dismal for stock prices to continue to falter.
A closer look at the yield curve
The yield curve inverted officially on March 21, 2019 where the 1-month notes were trading at 2.51% when compared to 5-year bonds trading at 2.34% and 10-years trading just modestly higher at 2.54%. On Friday, the bond market showed an even worse pattern where the 1-month notes traded at 2.49% versus 2.34%, 2.44% for 5 and 10-year treasuries.
While, the entire yield curve has yet to fully invert, it certainly could. This would in turn drive speculation to the bearish-end across various financial news journals. While this might flicker as a bearish signal for a while, it’s certainly unlikely that it signals the “peak” in the decade-long market cycle.
Stocks lost some momentum this week but it’s more likely a blip
The markets have experienced a minor pull-back on its way to its re-test to all-time-highs. At this point, it might be a bit of a slog when trending upwards, but there’s not much in the way of re-testing the resistance level at 2,925 given several more weeks if not during earnings season.
While the yield curve has partially inverted, there’s a heightened likelihood that the stock market will eventually shrug-off the week’s bad news going into the next week, where prices are a little cheaper, and buyers start to take advantage of the recent market dip.
Despite all the negative commentary over the prior week, it’s worth noting that markets tend to get jittery near a re-test of a market near all-time highs. This has usually been the case, as market strategists and analysts tend to become more skeptical of market momentum and look for any type of reasoning that might second guess a bullish stance on stocks.
A quick reversal in fortune, as equity outflows totaled $20.7 billion this past week, which were mostly driven by managed fund flows with $11.4 billion getting pulled from ETFs and an additional $9.3 billion pulled from Mutual Funds.
The reversal in asset flows mostly coincides with the recent price momentum we’ve seen in bonds, as investors look to get more defensive in response to recent treasury bond pricing trends.
It’s more likely that the stock price drop was more of a temporary blip, as the Volatility Index barely moved on Thursday or Friday for that matter. If things were really that bad, one would question why the market didn’t price-in much more volatility following what has been a purportedly bad week for stock investors.
It’s more likely that the volatility measure is continuing to trend lower on the charts, which obviously indicates that stocks are poised to trend higher in the following months or weeks assuming we’re witnessing a blip in selling, as opposed to a definitive shift in trend for stock prices.
Federal Reserve to the rescue?
While near-term indicators like the interest-rate curve flashed more bearish signals the Federal Reserve on the other hand offered some constructive commentary in their March meeting. The FOMC policy hovered just below the 2.5% interest rate forecast with the vast majority of policy members voting in favor of 2.4% interest rates, which is a dovish signal by the Federal Reserve, as it indicates that there might not even be an interest rate hike in 2019. This is actually better than what macroeconomists were forecasting for the year, as many were anticipating a single interest rate hike in 2019.
Without the risk of higher interest rates, bond investors may have just pilled into bonds, because they were trading just above the interest rate target set by the Federal Reserve, but now they’re trading closer to the 2.4% forecast across the entire interest rate curve.
This doesn’t imply that bonds are attractive, but they were attractive up until a week ago when the Federal Reserve offered a forecast just below the prevailing treasury yield rate. This then triggered an interest rate curve inversion with interest rates trending lower.
Federal Reserve FOMC statement highlights:
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.
The good news? Well, the Federal Reserve is going to be more “patient.” This more patient stance paired with interest rate targets that were below 2.5% paints a more dovish picture for stocks during the remainder of 2019. 11 FOMC officials anticipated no hikes, 4 expected 1 hike, and 2 expected 2 hikes, which could spark some opportunities in stocks that are more interest rate sensitive like REITs, telecoms and utilities.
The XLF or the Financial Selector SPDR Fund declined by 7% this week. Financial names struggled on the back of interest rate moves. Generally speaking, when the interest rate curve flattens/inverts (as it has now), it’s more difficult for financial sector firms to generate profits from lending activities.
When deposits are generating low yields, and lending doesn’t provide as much of a spread compared to risk-free interest rates, the current environment creates some challenges for financial institutions that generally prefer a steeper yield curve. Longer-term maturities should price a higher interest rate, but now it’s safe to assume that with interest rates trending lower, the banks may lower their mortgage prime interest rates, and also their various other lending rates for various financial products. This might create some shaky comparisons, and lower revenue figures relative to a firm’s balance sheet, which should be watched very closely.
Investors have steered clear of the financial sector as they’re more prone to financial market moves, and also dependent on market activity. IPO activity tends to taper off during more volatile markets, but with some high-profile IPOs such as Airbnb, Lyft and Uber this year not all is bad for financial sector stocks. Perhaps investment bank fee revenues could offset weakness in loan interest revenue.
Final thoughts
In prior market review articles I have maintained a bullish stance. The selling on Thursday seems more like a blip with most commentators and analysts blaming it on the interest curve yield inversion. Despite the weakness in market returns for the week, some of it could have been driven by confirmation selling on dovish commentary from the Federal Reserve and re-pricing of bonds due to the revised interest rate expectations that were more dovish in March than in the prior meetings.
While interest rate chatter will likely continue it’s more impactful when pertaining to financial sector names, which are more interest rate dependent. Hence, investors could avoid financial sector stocks, and look at other stocks that aren’t as interest rate sensitive like technology, biotechnology, and healthcare.
Furthermore, the uptrend in the S&P 500 hasn’t been broken yet. It’s more likely that buying will come back in full force over the next couple weeks. Whenever markets chatter near all time highs, it’s usually a sign that markets will likely consolidate (trade sideways) before eventually grinding higher. I still anticipate the markets to re-test the 2,900 to 3,000 zone for the S&P 500 over the course of earnings season with any further selling creating an opportunity to buy the proverbial dip prior to the beginning of Q1’19 earning season (middle of April).
