Markets chasing yield again

Life looks rosy again in the financial markets!

So going from the “the world is about to end” mantra in December, we’re back once again to sunny skies.

In particular, interest rate futures are projecting a rate cut later this year, which is a complete turnaround to events just three months ago.

So as a result, almost anything with a yield has been bidded up since the beginning of the calendar year.

It’s as if everything that has been thrown away in the previous rising rate environment is now back in vogue again. It’s like the proverbial crowd rushing out of the exits in December, only to rush back in January?

Very fascinating.

S&P/TSX 2019 year-end projections and predictions

Article on the Financial Post of various analysts predicting where the TSX will end up in 2019. Right now it closed at 14,222. I’ve put percentages next to the predictions:

Predictions for TSX at the end of 2019:
Laurentian Bank of Canada — 18,500 points (+30.0%)
BMO Capital Markets — 18,000 points (+26.6%)
National Bank of Canada — 16,600 points (+16.7%)
Russell Investments — 16,000 points (+11.1%)
CIBC — 15,600 points (+9.7%)
Sunlife Global Investments — 15,000 points (+5.5%)

I wish this list was more comprehensive. Sadly after doing a couple minutes of scouring the internet, I could not find a decent list of December 2018 predictions made in December 2017 other than Russell Investments predicted in late 2017 that the TSX would close 2018 at 16,900. I’m sure my readers can find a more appropriate list.

All I can say is the following – the numbers above also are based on a price index. The total return of the TSX includes dividends, and this would increase the stated percentages by approximately 3%. So the worst prediction of the six above would show a total return on the TSX of roughly 8.5%.

The TSX’s total return (dividends reinvested), as measured over the past decade, is approximately a shade over +5% compounded annually. Recall that 10 years ago was in the depths of the financial crisis and was one of the best investing opportunities in a generation.

If I was a broad market investor, I’d be concerned at this degree of bullishness.

No interest rate changes in 2019?

Take a look at the current snapshot of short-term interest rate futures (for those that do not know how they trade, ZQ is the 30-day Fed Funds rate futures and BAX are the Canadian 3-month banker acceptance rate futures, our closest proxy – the price is 100 minus the implied rate in percentage, so a price of 97.6 would equate to a 2.4% rate):

This creates some interesting financial bets, such as:

1. Do you believe the Fed will continue raising rates?
2. Do you believe the Bank of Canada will raise rates? If so, you can easily bet on this outcome. The next two policy announcements are on January 9, 2019 and March 6, 2019, and the BAX futures imply a very small chance of a rate decrease, but for the most part expect rates to remain the same (i.e. if you bet on the rates not changing you would stand to profit a tiny bit). The current rates as of today are 2.24% (97.76).

Given what has happened in the markets in the past three months, market participants are clearly pricing in that the central banks are going to stop raising rates. In particular, a quarter-point rise in the Bank of Canada rate will completely flatten the yield curve – currently 3-month treasury bill rates are 1.67%, but a quarter point rise will surely take them up to the 2 to 10-year level which are all currently trading around 190-200bps.

These are very strange times indeed.

The question then becomes a bit strange when one puts yourself in the shoes of the Federal Reserve or the Bank of Canada – do you want to raise rates to the point where you will invert the yield curve? It’s a bit gutsy to do so.

The Bank of Canada, as late as their December 5, 2018 policy announcement included the following sentence:

Weighing all of these developments, Governing Council continues to judge that the policy interest rate will need to rise into a neutral range to achieve the inflation target.

Does the Bank of Canada will believe that rates still need to climb to this neutral range?

For reference, the “neutral range” is defined as such:

The neutral nominal policy rate is defined as the real rate consistent with output sustainably at its potential level and inflation equal to target, on an ongoing basis, plus 2 per cent for the inflation target It is a medium- to long-term equilibrium concept For Canada, the neutral rate is estimated to be between 2.5 and 3.5 per cent. The economic projection is based on the midpoint of this range, the same rate as in the July Report.

The January 9, 2019 meeting is thus to be more interesting than most, considering what has transpired since the last meeting – including the Canada-China trade implications on the detainment of the Huawei CFO.

One of the likely implications of the realization of the cessation of rate increases is that there will once again be a chase for fixed income yield. It would probably open the door for more leveraged spread trading (e.g. borrow CAD at 2%, invest at 6% type trading, with the knowledge that the 2% borrow rate will not get more expensive).

The other observation is that the central banks might pause, but if markets start to normalize once again, may continue the tightening bias. Indeed, the Federal Reserve is still implicitly tightening with the reversal of QE and keeping this chart in mind (FRED Data) makes one realize there is a long way to go before things normalize on the Federal Reserve’s balance sheet.

Markets bounce back on boxing day

I will offer some commentary about today’s market action. I wasn’t expecting to write this so soon.

Back on December 20 (which was less than a week ago!), I wrote the following:

My gut feeling suggests that we need to see more of a washout. We are likely to see a huge market rally at some point in the near future (you’ll see the S&P 500 jump up 5% over the course of a few days), and this will simply punctuate the next part of the downtrend – recall that the biggest rallies occur in these down trending markets. It is exactly designed to coax non-committed capital into the marketplace under a false pretense.

When closing the part day on Christmas Eve, the S&P 500 powered down over 2% and given what has happened during the month of December, I do not think traders wanted any risk positions exposed during Christmas.

Now we’ve got our market rally. It’s happening right now, all in a day. There will be a week or two of more positive market action. We will get a partial recovery and institutions and investors will feel more comfortable again. We are going to hear headlines such as “the economy is fundamentally in great shape”, and “unemployment is low”, and “America is still the economic engine”, etc, etc., but all of this is going to be a complete smokescreen.

Now that the mini-break period is over, today we saw the S&P 500 rocket up nearly 5%. The TSX is closed for Boxing Day, but it is very likely to trade up on Thursday as a result. It will get sold after the morning – when this will start, I don’t know.

In bear markets, the rallies are the swiftest and the most punishing for short sellers. There are a few reasons for this. Rationally, you have some balancing re-allocation from fixed income to equity from portfolio managers that keep fixed allocations of asset classes. The more emotional component is that money flows back into the market to avoid missing out on the bottom (the so-called “buying opportunity of the year”). For the past decade, participants have been conditioned to believe the the markets will bounce back. We saw this in August 2011, October 2014, February 2016 and even as recent as this Spring, where markets took a 10% dip and recovered to all-time highs.

I will claim things are different. What is different this time? The state of monetary policy. I have written about this in detail in previous posts.

Keep solvent. Cash is always a valuable commodity, but especially during these times. Preparing to watch out for forced and spontaneous liquidations will be the best way to make money in 2019, not by index investing. Indeed, those with the buy-and-hold mantra will have their nerves continually tested in 2019 – how much bleeding can they take before they will cash themselves out?

Investing is never easy, nor will it ever be. Looking at the retail side of things, firms that make ETF investing and robo-investing sound easy as opening an account, funding it, and choosing some mix of ETFs make the financial markets look like automated cash machines. Now these same people are realizing that there is indeed a flip side to the proposition – markets can also go down.