U.S. stocks and bonds have in the past few weeks moved in the opposite direction of where they had moved since early March. For example, the S&P 500 has fallen close to 60 points from its June 12th peak, which was its high for this year. In a similar vein, the 10-year's yield has fallen about 50 basis points from its 2009 high of 3.99%, set within hours of the equity market's move. Inflation expectations, which for the U.S. Treasury's 10-year inflation-security had peaked at 2.09% on June 10th (the market was priced for the consumer price index to increase at a 2.09% annual rate over the next 10 years), have since fallen back to 1.62%. Commodity prices, which had been rallying, have reversed, as has the U.S. dollar, which has been gaining of late.
There are many who would say that these moves in the financial markets are technical and need be put in the context of the trends that preceded them. Here are a few notes on some of the key fundamental factors that are moving the markets:
• The recent decline in Treasury yields reflects a reassessment of the “green shoots” idea. It could be said that the markets are in a “now what” phase, where investors have priced out Armageddon but are unsure about how far the recovery will go.
• In other words, there is a limit to how far yields can climb on the 'green-shoots' concept and until there are signs that the economy is moving toward a self-sustaining condition, yields are likely to stay low, particularly on the short end of the yield curve.
• It remains questionable how well the U.S. economy can fair without the help of government support. This favors a low fed funds rate, for example. The Fed appears to be concerned about the possibility of a relapse and will be unwilling to withdraw stimulus except for a natural unwinding of some of its support programs.
• A major obstacle to growth is the continued lack of credit creation in the U.S. banking system, where weekly loan data continue to show steady declines. There is not “velocity,” in other words; Federal Reserve liquidity is not yet moving out the door from the banking system.
• Growth will be slow to return in part because a large amount of jobs lost are “permanent” job losses. Data from the BLS show that roughly 4 million of the 7 million jobs lost during the recession are “permanent.” (see chart in separate email).
• U.S. consumers are of course in the midst of repairing their balance sheets and this will last years. Consumer spending will be held back by the de-leveraging and other factors such as demographics (the aging population will be leery about spending ahead of retirement. Moreover, they will be more risk averse than before having gone through several shocks over the past decade. This will be reflected in a lower equity risk premium, for example.
• Treasury supply matters, but it matters most in bear markets when investors tend to demand larger concessions. Still, he said the influence of supply is increasing and there is an as-yet unknown limit to how much supply global investors can and are willing to absorb.
• China’s persistent squawking about the U.S. dollar’s reserve status is a continuation and perhaps a hastening of the 7-year diversification idea that has brought the dollar down to 63% of world reserve assets from 70% in 2002. China is not ready to take the mantle:
1. It has no bond market for which to house the world’s reserve assets
2. Its unilateral currency swap agreements with other nations are targeted toward trade, not finance.
3. Chinese companies cannot yet raise money offshore in their own currency. This will stymie globalization of the renminbi.
• That said, the question of our age remains: If the U.S. is backing its financial system, who is backing the U.S. Without an affirming response, there remain risks to the U.S. in the absence of a restoration of fiscal prudence.
So, as you can see, along with many other factors, there are plenty of fundamental factors that can help explain the recent behavior of financial markets.
Disclaimer: This article contains the current opinions of the author but not necessarily those of PIMCO. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on CNBC and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."