Japan has had to intervene to shore up the falling yen for the first time since 1998, despite trying to keep interest rates low.
The world has been addicted to cheap money for years. Now let’s see what the withdrawal looks like.
Raising interest rates from zero has led to an historic bond crash, observes Bank of America’s strategy team led by Michael Hartnett. This year’s losses can be combined with the worst bond declines since the aftermath of the two world wars (1949 with the Marshall Plan and 1920 with the Treaty of Versailles) and the impact of the Great Depression (with the collapse of Creditanstalt, a major European bank, in 1931). .
This is the product of the end of near-zero interest rates, with the Federal Reserve raising its benchmark interest rate by a total of three percentage points in 2022, including another 0.75 points over the past week. Equally important, this has pushed real, or inflation-adjusted, rates well above zero. The five-year real yield as measured by inflation-linked government bonds has risen to a positive 1.60% from a negative 1.61% a year ago, according to Bloomberg.
Dramatic bond repricing threatens “the world’s busiest trades,” write BofA strategists in a client note: the dollar, US tech stocks and private equity. There is also a risk of a “credit event” – the polite term for a crash.
The preconditions that led to the October 1987 crash were largely in place, they add. These include a volatile geopolitical backdrop, abnormal US markets that far outperform the rest of the world, and a lack of international coordination. What is still missing is a currency crisis.
But FX volatility has increased
US dollar index
surged to a 20-year high, causing huge drag on other currencies. The most notable loser: the British pound as markets reacted violently to the UK’s plan to borrow to fund tax cuts. Japan has had to intervene to shore up the falling yen for the first time since 1998, despite trying to keep interest rates low.
For now, the bond carnage has caused all but the 20 percent bear market decline in major stock indices
Dow Jones Industry Average,
which corresponds to a decrease of 19.6%. So far, the declines mostly reflect lower price-to-earnings multiples; Cuts in earnings forecasts are only just beginning. Goldman Sachs strategist David Kostin has cut his year end
Target from 4300 to 3600, assuming higher interest rates earn a P/E multiple of 15 times assumed S&P earnings per share of $234 in 2023 (or just below the Wall Street consensus of $240.46 from FactSet).
But Jason De Sena Trennert, who leads Strategas Research, sees an earnings recession that could push S&P earnings down to just $200 in 2023. Earnings recessions are typically twice as common as economic downturns, and this would reflect the faster rise in producer prices than consumer prices, he argues in a client report. However, the estimated drop of around 10% would be far less than the median drop during a recession. And the falling earnings estimates could mean the next phase of the bull market is upon us, he concludes.
Using Goldman’s estimated 15x P/E and Strategas’ $200 earnings forecast implies an S&P 500 target of 3000. That would be an additional 18.8% discount to Friday’s close of 3693.23, which was already 23 March % below benchmark closing high of 4796.56 is on Jan 3rd.
Frequent readers of this column may recall that the S&P 3000 was also the prediction of former Barron’s Roundtable researcher Felix Zulauf. He made that prediction last December when the large-cap benchmark was hovering near the 4800 peak. Since then, however, he has maintained radio silence and unfortunately has not issued any updates.
As for BofA’s Hartnett, he suggests investors “nibble” when the S&P 500 hits 3,600, “bite” at 3,300, and “eat” at Zulauf’s 3,000 target. Further rate hikes by the Fed could put pressure on equities and other risky assets. Futures markets are pointing to a further 0.75 percentage point gain in November and 0.5 percentage point in December to 4.25% to 4.50%, according to website CME FedWatch. This is in line with the Fed’s year-end forecast.
But on Friday there was a big contrarian bet in the sophisticated world of interest rate futures options. Someone has bet rates won’t rise as much as expected through December, reports John Brady, managing director for global institutional sales at Chicago brokerage RJ O’Brien, in an email. That suggests someone is preparing for something to break, which usually happens when interest rates rise sharply.
write to Randall W. Forsyth at [email protected]