Week ended March 11, 2022
It was another highly volatile week in both the bond and equity markets, with the day-to-day fluctuations really quite remarkable. For example, the S&P 500 was down big Monday, flattish Tuesday, up big Wednesday, flattish on Thursday and down again on Friday. The so-called “equity fear index” – the VIX – peaked on Tuesday morning at 37.47, not far off its 52-week intraday high, before declining the rest of the week to settle at 30.75 on Friday. Similarly, the index that measures short-term bond volatility – the MOVE index – came off its Monday afternoon high of 140.03 to close the week at 99.03. The invasion of Ukraine by Russia continues and – if anything – is broadening and escalating, whilst the news on inflation in the US and the Eurozone was anything but comforting. So why are the volatility indices falling? My view is that investors are increasingly incorporating a longer Russia-Ukraine war and high (and increasing) inflation into their base case scenarios, resulting in greater confidence (i.e. lower variation / more conviction) that both bonds and equities are heading in one direction, which is lower. One thing for sure is that the decrease in volatility has not interrupted the migration into safe havens at the expense of risk assets, as both the US Dollar and gold have continued to rally albeit both came off their intra-week highs by Friday’s close. Similarly, oil seems to have overshot fair value with the price of WTI crude settling at $109.33/bbl on Friday, down 5.5% WoW, and well off the intraday high earlier in the week of $130.50/bbl (Monday). We are at the point as far as sentiment where any sliver of news suggesting a solution to the Ukraine-Russia conflict causes oil prices to fall sharply, and any news regarding an escalation in the scope of the war or related sanctions causes oil prices to skyrocket.
As far as inflation, US CPI for February came in at 7.9%, (see US BLS press release here), a 40-year high but largely in line with expectations, whilst flash inflation in the Eurozone was 5.8% for February (see Eurostat press release here). The ECB released a Monetary Policy Statement on March 10th, and ECB President Christine Lagarde followed this with a Q&A which I found awkward and somewhat confusing. At times, Ms Lagarde seemed like a deer caught in headlights, probably reflecting greater dissension within the Governing Board and – according to the press – a more hawkish tilt at the ECB as inflationary concerns rise to the forefront. The Fed has teed up a well-advertised 25bps increase in the Fed Funds rate this coming week, with more rate rises likely to follow, whilst the ECB was non-committal on timing for specific timing for interest rate increases although the ECB is winding down its bond purchases slowly. Indeed, Europe seems to be in more trouble all of a sudden, not just because of soaring inflation in the common currency zone, but also because the European economy will be much more negatively affected by the ongoing Ukraine-Russia conflict (than the US). If I were placing bets on stagflation in the coming months, I am all-in on Europe because the economic bloc faces a much more challenging task to curtail runaway prices without further causing an increasingly fragile economy to tank, although the Fed will also have to thread the eye of a needle to navigate a soft landing. If you pay attention to the US Treasury yield curve, it continues to scream “recession” down the road, sooner rather than later, as the curve flattens.
I am also keeping an eye on corporate credit now, because as I have written in the past, the direction of credit spreads probably says more about where we are heading than the direction of equity prices. In the corporate bond market, the European high yield market continued to bear the brunt of the sharpest sell-off, reflecting the fact that – like European equities – European high yield bonds are closer to the epi-centre of the ongoing Ukraine-Russia conflict and the uncertainty this entails. However, USD-dollar denominated corporate bonds were also significantly weaker across the credit spectrum this past week. USD-denominated BBB (i.e. investment grade) corporate bond yields were 33bps wider W-o-W (to 3.83%), a significant widening for high tier corporate bonds. Yields on high yield bonds also widened sharply WoW, by 45bps (USD) and 42bps (EUR). As I mentioned earlier, the fact that the normally much more stable EUR-denominated high yield bond market has weakened so much and so quickly says a lot about risk appetite. In fact, yields on European high yield bonds are 120bps wider just in the last month! If you want to look more closely at historical spreads and yields on corporate bonds, tables for each can be found here. [REFERENCE]
Keep in mind this week that both the Federal Reserve (March 15th-16th) and the Bank of England (March 17th) will have policy meetings, with both central banks expected to raise their overnight bank borrowing rate.
In global equities, European bourses staged somewhat of a recovery this week, even as stock markets elsewhere sagged. Emerging markets equities were the hardest hit, down 5.2% WoW. None of the markets I follow have been spared this year, with all red now YtD. The STOXX 600 has been especially hard hit, going from “hero to zero” this year as Russia’s invasion of Ukraine has badly undermined confidence in the Europe and dampened expectations regarding economic growth for this year and next.
As far as US equities, the recurring theme of higher inflation (leading to higher yields) affecting the tech-heavy NASDAQ the worst continued, with this formerly high flying index down 3.5% WoW and negative now for the last 12 months running. The value-oriented Russell 2000, consisting of smaller companies, had the best relative performance this past week (if we can say that with a straight face), down “only” 1.1% WoW. The week for US equities ended on a strong, concerning as we look forward to this coming week. I do expect institutional investors to step in to provide support if this sell-off continues, simply because valuations have fallen and the US economic outlook does not seem so bleak albeit there is uncertainty on the horizon.
As the Ukraine-Russia was settled into the normal narrative, concerns regarding inflation and the Federal Reserve’s pending steps to dampen inflation retook centre stage, certainly in the States. US Treasuries suffered a sharp sell-off as the safe-haven focus gave way to concerns over inflation and the pending Fed tightening that is coming. The yield curve is not inverted, but it has flattened considerably as the 2-10 year spread is now hovering around 25bps, its tightest since the onset of the pandemic. This is signalling a reasonable possibility of a recession ahead, as the Fed shifts hawkish and risks going too far too fast, causing economic growth to stagnate. A recession – or worst yet stagflation – could very well be the price of “too little, too late” for the US central bank.
The shorter end of the government bond curve more accurately reflects what the central bank policies should be. As you can see in this table below to the right, the overnight bank borrowing rate (i.e. the
cost of banks borrowing from the central bank, bottom line) is closer to the 2-year government bond yield in the UK and Eurozone than in the US, clearly signalling that investors believe the Fed has a lot of rate increases in the coming months. It also reflects the fact that the Fed has been too slow to act, as bond vigilantes have gotten ahead of the Fed. However, bond investors are also betting on further rate increases in the UK (likely this week), and eventually in the Eurozone, although timing in the common currency bloc feels much more squishy.
As far as safe haven assets, both the US Dollar and gold continued their ascent, although gold did come off of its mid-week high above $2,000/oz. The Yen suffered (again), more due to US Dollar strength per se than Yen weakness.
As you can see in the FOREX portion of the above table, both the GBP and EUR have weakened considerably vis-à-vis the US Dollar. As already mentioned oil prices came off of their highs but directionally are very dependent on news regarding the Ukraine conflict and sanctions on Russia. Bitcoin and cryptocurrencies more broadly were weaker this past week but only marginally. I must admit that I continue to be impressed at the resiliency of this difficult-to-understand asset class.
The two tables below show the migration in yields and spreads in corporate credit, both of which have been worsening this year. Recently, the widening has accelerate, especially in the European high yield market.