The primary driver of the selloff was a result of dramatically rising interest rates. On Friday the closely watched US 10-yr yield rose 2.92% to close at 2.85%. Not only is that the highest yield for the 10-yr. over the past 12 months, it is it’s highest yield since January 6, 2014. That lurch higher in rates has altered the landscape for investors in a potentially meaningful way.
Including last week’s selloff, the S&P still has a relatively elevated P/E of 22.47 and a 52-week gain of 22.62%. It could be argued that as a result of stretched valuations alone, equity markets have been due for a pullback and ultimately a degree of valuation compression.
That valuation-centric premise has been buttressed by a dramatic shift higher in T-note yields – a move long anticipated but delayed by Federal Reserve monetary policy.
On Friday, the dramatic turn lower in equity prices coupled with the equally dramatic rise in interest rates was captured by the long-dormant Volatility Index (VIX). On the day, the VIX sharply rose 28.52% to close the session at 17.31 – the highest close since October 31, 2016.
We have finally reached an inflection point in markets. The long-awaited confluence of rising interest rates, fueled by improving inflation metrics found in employment and other economic data, has fueled active hedging on the part of portfolio managers. Traders are expecting the recent turn higher in rates to materialize as a trend. By historical standards, interest rates are still relatively low, and if forecasts for increased economic activity, continued gains in employment, expanding GDP and improving corporate results are any indication, they could potentially rise meaningfully higher in coming quarters.
In the first FOMC meeting of the year last week, the Fed left rates unchanged, as expected, but did lay the groundwork for further tightening in 2018. That guidance on Wednesday in conjunction with the Atlanta Fed’s call for a Q1 GDP reading of 5.4% on Thursday fueled a shift in investor expectations that lulled even the most hesitant bond bulls to reverse course – putting an exclamation point on the thesis that the 30-year bull market in US Treasuries has come to an end.
Update on prospects for another government shutdown:
Adding additional pressure and uncertainty to the investing landscape is the prospect of another Federal government shutdown in the near term, as I discussed in the article I wrote for Yahoo Finance, published last Monday, January 29: “Why another government shutdown is coming and could be worse.”
Last week’s turbulence in US equity and credit markets did to a degree also spill over into energy markets. US WTI crude prices moderated during the week. From Friday, January 26 through last Friday, February 2, WTI slipped 1%. Though I do expect continued expansion of US shale oil production to impact energy prices in the form of a headwind, consumption will remain strong. Weakness in the US dollar should act as a counterbalance to that theme.