Central banks are no longer supportive
While investors continue to cheer robust earnings and new records in equities, central banks are no longer the market's best friend.
Bank of Canada was the latest to surprise investors with a sharp U-turn in policy by ending its bond-buying program and pulling forward the timeline for interest rates hikes. Monetary policy officials admitted that higher energy prices and supply bottlenecks appear stronger and more persistent than expected. Hence the shift in policy is not driven by growth optimism but fear of persistent higher inflation.
BoC's decision drove the Canadian dollar higher against its counterparts, which is a normal reaction to the hawkish tilt. However, the more significant response was in government bonds, where the yield curve flattened on Wednesday by the largest magnitude in almost 20 years. The short-term rates are now driven by expectations of early rate hikes, while the longer ones are pulled down due to lower expected growth into the future.
A similar reaction was seen in UK bonds earlier this month as traders expect a BoE interest rate hike as soon as December. Meanwhile, the Federal Reserve's chances of two or more rate hikes have grown to 82% according to CME's Fedwatch Tool.
Higher interest rates expectations are not good for stocks, especially growth ones where cash flows are discounted well into the future. However, the reaction in equities have so far been muted with the S&P 500 continuing to make record highs. Risk assets haven't been impacted so far because of the solid earnings with more than 80% of S&P 500 companies delivering better than anticipated results. Another valid reason to remain in stocks is real yields. When we deduct inflation from yields, we realize that real yields remain in negative territory and near historic lows. So, investing in government bonds with the aim of holding them until maturity, you're guaranteeing a negative return on your investments. That what makes investors hold to their risk assets despite overstretched valuations.
Today's US GDP release is an interesting one. Growth is expected to have dropped to 2.7% in Q3 compared to 6.7% in the previous quarter. However, the spread between economists' forecasts is extremely wide with some expecting no growth at all happened during the last three month. If that's true, the fear of stagflation will intensify, and investors will shift attention from earning to economic reality.