Watch 10-year Treasury yields for signs of danger in 2018
Investors should stay in stocks as a big bear market looks unlikely as early as 2018
This can’t carry on, can it? This is the last Long View of 2017, the most serenely positive year for world markets in history. US stocks varied less than in any year on record, bar 1964; the MSCI World index made a gain in each month, for the first time ever, and anyone betting against volatility with inverse Vix index exchange-traded notes could have tripled their money.
At this point, columnists such as me are supposed to make predictions. I did not see the calm sea and prosperous voyage of 2017 coming. As 2017 was literally as good as it gets, it is a very safe bet that 2018 will be harder, but that does not mean that it will be a bad year. Arguably the most important force in markets is momentum; once prices are in motion, they tend to keep going in the same direction for a long time. Something needs to interrupt them.
The factors that helped investors to such success in 2017 included surprisingly strong and synchronised global economic growth, and surprisingly good growth in earnings, low inflation and very easy monetary policy — with asset purchases from the European Central Bank and Bank of Japan counterbalancing rate rises at the Federal Reserve.
Entering 2018, the US has made its corporate tax cut, the effects of which should start to be felt in 2018. China, with Xi Jinping reinstalled and stronger than any Chinese leader in a generation, appears set to rein in its overblown property market and cut back on its overextended credit. Central banks will — if they are to be believed — start to reduce liquidity.
So the precise constellation of conditions that made 2017 so good will not continue. But that does not prove that there will no longer be easy gains from the stock market. If earnings do increase, that will help stocks (the consensus prediction for this quarter is 12 per cent growth, according to Thomson Reuters, with double-digit growth rates to continue throughout next year).
Valuations are excessive, particularly in the US. Over 10 years or more, that matters a lot. But over one year, valuation says almost nothing. US stocks could easily get more expensive.
What would suggest an imminent downturn, then? Generally, volatility increases for a while before the sell-off starts. With markets this calm, we should expect volatility to pick up for a while before converting into falling share prices. Sell-offs also generally require a recession and none looks imminent at present.
A classic bond market signal of impending recession would be an inverted yield curve in which long interest rates are lower than short-term rates — a sign of negativity for the future. The US yield curve is flatter than it has been since 2006 but it is still positively sloped.
This brings us to the two most important questions for markets. First, there is the dollar. One of President Donald Trump’s greatest feats has been to weaken the dollar, as he wished, after years in an upswing. This let emerging markets off the hook from a possible currency crisis, boosted US competitiveness and made dollar-denominated returns look great.
Can he continue with that trick? If the tax cut sparks higher rates (which would attract money to the US) and a significant repatriation of US cash back to the homeland, the odds are that the dollar will rise.
The critical dimension is the bond market. At present, the imminent risk appears to be overheating. That implies higher short-term rates from the Fed and higher yields on longer-term bonds. And that brings us to the longest-running and most important market trend of them all.
The 10-year Treasury yield, arguably the most important number in world finance, which sets the notional “risk-free rate” in global transactions, has trended down steadily ever since Paul Volcker’s Fed stamped out inflationary psychology in the early 1980s. Bond yields have ticked up since the tax cut passed and are very close to breaking above that steady downward trend.
Scepticism about chartism and technical analysis is always justified. But sometimes a trend is so obvious and strong that it is foolish to deny it. If the downward trend in 10-year yields were at last broken, it would be profoundly important.
Most traders today have no idea what it is like for yields to trade upwards. It would open the risk of a financial accident. Sharply higher yields would crimp the economy, put over-extended corporate credit under pressure and render high stock valuations impossible to justify. It could change everything for asset markets.
This is a real and present danger. If we exclude unmeasurable risks of warfare or natural disaster, it is by far the greatest risk facing asset markets.
But this is a trend that will not give up. The latest trend line follows a slightly different slope from the trend line that was drawn on to charts before the summer of 2007. Back then, for a few days on the eve of the credit crisis, yields broke above their old trend, sparking a minor panic. One trader said that “if bond yields rise further, the herd may start to run”.
The herd did, of course, start to run. But 10-year bond yields fell again. Every other trend seemed to break but Treasury yields kept falling. The forces pushing down on them, including an ageing population, low inflation and the intervention of central banks, have been resilient. This trend must break at some point. It must. But it is not safe to bet that it will happen in 2018.
Where does that leave us? On balance, investors should stay in the stock market, as a big bear market looks unlikely as early as 2018 — but carry more in cash than usual and substitute cash for some bonds. That approach would have done fine last year in absolute terms; but you would have missed out on the best of some very easy returns. For 2018, I suggest running the same risk of missing out a bit again.
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