Stocks had a pretty big selloff today in response to a big drop in the bond markets.
For those of you keeping score (the baseball kind, not just the points scored), here is the way the game looks so far.
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- US economy is still expanding, making it one of the longest economic expansions
- The economy itself is cyclical. It ALWAYS goes up AND down. So, if it has been going up for a very long time, sooner or later, there will need to be a correction, or recession. How hard the recession ends up being is a function of how it hits. A “pop” leads to a hard (potentially shorter) recession. A “soft landing” means markets can regroup and reprice (usually with a lot of sideways movement) without shocking the system.
- The Fed keeps raising interest rates because… well, because they want to be “hawks” and not “doves” and just for the barest of moments, the supposed “target” of 2% inflation was touched, so here comes the Fed.
- The Fed not only keeps raising interest rates, it keeps saying it is going to raise interest rates more. One more hike this year, in December, and three next year. That’s a lot of increase.
- The bond market is starting to notice. Why would you take on a 10-year Treasury now, when you know in a year, the rate on a 1-year Treasury might be just as high?
- This is called a compressed yield curve. Usually, you get more reward (higher interest rate) in relation to more risk (longer holding period). These days, there hasn’t been much spread between short-term rates (the ones the Fed moves) and longer term rates like the 10-year interest rates.
- Anyone who has ever played with a rubber ball knows that the more you squeeze it, the more it bounces back when you finally let go.
- The yield curve has been getting squeezed more and more. The last squeeze was in September, the next one is coming in December. The bond market reacted with a boing.
- Why Now?
- This one is kind of fun. There was a change in tax law reporting that made big purchases before September 30 much more advantageous than purchases after.
- Anyone who needed to buy a big chunk of 10-year Treasuries did it in September instead of October.
- Once the big buyers moved out prices naturally fell in response (more supply, less demand).
- Once they moved down, they triggered selling by other investors, which pushed prices lower, which triggered selling by other investors, which pushed prices lower…
- Now, 10-year Treasury rates are higher. Higher enough that it is going to start affect mortgage interest rates, and…
- The housing market was just starting to show signs of slowing down. Higher interest rates would turn a slight slowdown into a full bloom slowdown.
Crystal Ball Time
What happens next?
As always, predicting the future is tough. But, here goes.
In one scenario, U.S. companies are still doing just fine. Earnings are still strong. Workers still have plenty of jobs, even if pay isn’t really increasing. It’s frankly probably a good thing if housing prices aren’t rising so fast. – In this case, there will be some volatility while the markets reestablish equilibrium, but in the end, the expansion continues.
In the other scenario, U.S. companies are doing well, but not THAT well. With no more momentum toward higher stock prices, the markets stall. Yet another interest rate hike is coming and everyone reacts. Higher interest rates drive the housing market lower. Less housing, means less housing starts, which means less housing jobs. People also don’t refinance since higher rates makes it less attractive. They don’t use the equity in their house for remodels, vacations, whatever. Fewer jobs makes people less confident and they cut back on spending. That creates a hard shopping season, which tips over the retailers in the markets. Computer programs kick in and do the rest of the damage. The recession begins, once again triggered by a Federal Reserve that HAD TO raise interest rates not because the data compelled them to, but because they were “hawks”.
Which scenario is it this time?
I don’t really know, but what I do know is that Scenario 2 is coming. I just don’t know if it is now, or later.