State of Capital: Vol. 3


With a warm welcome back to volatility, it is obvious that much has changed since the last edition. The market is swinging and twisting and back from its 14-month hibernation. We blinked once or twice as the 10% correction that everyone and their brother was anxious about registered with Standard and Poor’s. Jerome Powell took office as Federal Reserve Chair coincidently as the preceding story unfolded. Yields moved higher and like equities, briskly. Ending the year around 2.4%, the yield on the 10-year Treasury Bond made a b-line for 2.8% for the first time since early 2014.


Oil experienced a similar amount of movement with equities, bouncing from $66 to $59. The price swiftly settled in around $62. This peak to trough 10% loss is like the equity market for two reasons. First, for no apparent reason it rebounded quickly and second, it was coming off a high base. For some context, oil was exchanging hands as low as $45 in June – $66 may have been an overshoot.


Let us not forget about the almighty US Dollar- what a fall from grace it has seen. Over the last twelve months the Euro appreciated against the greenback over 19%. Year-to-date the Japanese Yen has been dominating. As a net importer, all of this points to higher inflation because a weaker Dollar predicates more expensive imports. This depreciation and implied increase in prices has far reaching consequences. It will show nominal growth, for sure, but besides its debt deflation properties, growth adjusted for inflation (real growth) is what strong economies are made of.


The most important prices in the investing world, interest rates, have much to say about this. Short rates are set by the Fed and roughly projected. The long end of the curve is supposedly market decided, save for any quantitative easing. The inputs to the rate of interest on, say, the 10-year government yield include the rate of shorter maturities, the rate of inflation, a premium for reinvestment risks and a premium for locking your money up for that extended term. With higher expected inflation via a cheaper Dollar, we have seen a brisk rise in the long end and by default, an increase in the 10-2 yield curve. This could change as the Fed is no longer buying these securities and The Treasury is issuing a lot of short maturity debt.


In conclusion, all dollars must go somewhere. Whether they are headed for consumption or investment, there is bound to be a bubble when there is too much credit in the system. Whether we are there or not is a question worth attempting. Credit Suisse thinks a 3.5% 10-year will cause pain in the equity markets. If one were to sum the expected Fed rate hikes this year and add to that the current spread between the 10-year and that rate, we would be two basis points away at year end. This is all variable and will most definitely not go according to exact plan, but based on these estimate we could see a deflation of dollars in the S&P.

Yield Curve

The spread between the 10 year Government Bond yield and the 2 year Government Note is 0.64%. This is a bit higher than 0.51% which we had seen within the last few months. An increase in supply of short term government paper is likely to augment supply. Supply means the price of the bond should go up, increasing the 2-year yield. Thanks to increased government spending – on credit, of course – the longer end of the yield curve has blown up as well, possibly due to inflation and growth expectations. With a rise in short-term rates and a larger absolute rise in long-term rates, a steeper curve it is.

Junk Spread

A sliver less risk is being taken in the junk bond market, at least according to this metric. Below-Investment-Grade bonds are exchanging hands at lower prices than the last reading as indicated by a larger yield spread. Because bonds move inversely to their yield by nature, this points to more risk aversion and less yield reaching. While this is important, so are the protections afforded to these investors by law. The level of protections is still low as yield (read reward) is still more important to most than risk to buyers. This is cause for concern if you view the world through Benjamin Graham’s eyes.


For at least a moment, equities became cheaper. This blip is irrelevant when it is viewed with a longer-term perspective. The chart below gives us such.

The size of the stock market against the size of our economic output is one way to view relative value. Here we see excitement and opportunity priced in as the size of the stock market advances. On a positive note, earnings have been strong and growing. 15% for Q4 2017, which according to Factset is the highest since Q3 2011. No matter, equities are by no means cheap. Interest rates have made an aggressive move upwards while their capital structure counterpart has apparently digested the news. Parabolic? It sure looks it.

Interest rates are low, taxes are going lower, unemployment is low, and people are optimistic. With all the standard boxes checked, what other positive catalyst could possibly push more money into this market?

Monetary Policy

Rates are on the move up, but as more people were staring to believe in 4 rate hikes during the calendar year were likely, the stock market got caught up in a short volatility unwind that sent prices spiraling- if only for a few days. In any case, the wealth effect of rising stock prices aids in consumer spending, so anything that threatens a fall from these propped-up multiples threatens a sort of psychological monetary policy. In short, falling stock prices are a type of monetary tightening, if only in the mind and on paper.

Short-term rates are still historically low, but in the case of an economic downturn pulling those rates down can only go so far. This is what puts the Fed between a rock and a hard place. If this were to occur and a rate-paying asset frenzy were to reoccur, I would assume they would take a page out of Japan’s playbook and start buying equity ETFs to keep the wealth effect in place. In the world of monetary policy, it has been proven that anything is possible.

Financial Conditions

Using the 105 risk, credit and leverage metrics involved in the National Financial Conditions Index of the Chicago Fed, we see that conditions are easier than history’s average would dictate. This index factors in “shadow” banking activities to give a more robust picture of money growth in the economy. Finance is a lot like fashion in that both industries are cyclical – risk is in.


What a strange market we a lucky enough to be a part of. While QE isn’t a new invention, it certainly is in the context of modern and interconnected markets. With this experimentation of the Monetarists we will see new things and have new data to gather to help us in our future understanding of the markets. What can be taken from this is that most everything is expensive. A significant number of these new dollars printed have gone to risk-assets, creating a price rise. Stocks aren’t cheap, bonds are rich and cash has destroyed purchasing power and careers. It is best to stay aware of all of this as we are expected to see multiple rate hikes that have been known to be fatal blows to the bull market parties of past.