The Great Market Reset
An inconvenient thing happened over the last week in the financial markets.
Inconvenient?
Indeed. The markets have been powered in the last one year since the the start of the pandemic by the expectation of a economic collapse, the worst in a hundred years, then of a rescue of the global economy by governments in the world who are throwing everything at their disposal to turn it around. Warp speed vaccine development, an impressive rollout of vaccinations by the BIden Administration seems to "flatten the curve" and of course, tons of money shoveled out of government coffers into the hands of the people who lost their jobs because of pandemic lockdowns have been the highlights of the world economy up to now. Then over the last few days, all of a sudden, the mindset of markets is of a faster than expected economic recovery. And no more easy money.
That reassessment happened in the blink of an eye. For what it's worth, the thinking suddenly turned to focus on a future inflation that has not yet begun to be visible even with a Hubble telescope. But with the comfortable feeling that the US Fed Reserve would be accommodative forever, to burn money to fuel the recovery vanished overnight and became an inconvenient perspective that spending at that rate would be the fuel of a massive inflation in days to come. And even as the Fed Chairman said in as many words that US interest rates will remain at zero, and that the feared inflation is far from even their own modest target of 2% (now at 1.5 percent), interest rates in the long end of the spectrum of interest-bearing securities went up, and the bond market collapsed.
The actual rise in the yield of the bellwether government bond, the US 10 Year Treasury from its lowest point during the summer, from 0.5 percent to 1.5 percent was just that. One percent. Over a ten year holding period, as the bond implies, that 1 percent rise per annum rise represents about a ten percent fall in its immediate value. For bonds, it is not an insignificant amount, but it is also not disaster. Of course, there may be more such reassessment of economic recovery in the days to come, and heightened inflationary expectations, so that the fall may become larger shortly.
But that is not the point. The point is that the convenient cosy feeling that the US Fed Reserve has your back, as investors go out on a buying spree of everything, from bonds to stocks to gold to crypto currencies, is essentially over. Even if the Fed adamantly says they will stay supportive.
That is the nature of market sentiment. The truth does not matter; the perception is all important.
The markets therefore had on a great reset. Bonds prices crashed as yields shot up. Equities retreated from the record highs, as funds and other institutions took the chance to lock in some profits from the long rally since April 2020. Foreign exchange markets abandon the stale tale that when the pandemic is over, the retreat from the safe haven in the US dollar from economic uncertainty would weaken it, Some say that the decline would be up to 1/3 of its value.
Instead, the strongest currencies during the pandemic, which had the lowest interest rates, like the Swiss Franc and the Japanese Yen tumbled against the Dollar in recent trading sessions. It will soon be the Euro's turn because the 10 bond yield in Germany is minus 2 percent, and when the US 10 year bond yield is at 1.5 percent, the 3.5 percent gap is too large to be ignored.
There will no longer be one single factor affecting bonds, stocks and currencies - the uncertainty over the pandemic will now become a fear of overly strong recovery, bringing with it the pressure to cause central bankers to abandon their stimulative policies. The main concern is of course that free money is no longer available, not that inflation is anywhere to be seen.
The wild passion for esoteric investments which bear zero yield and lots of risk will fade. In particular, Gold will lose its luster, after it peaked in August last year. In this blog, we called the bottom of the stock market in early April, as well as the top in Gold in August. We also did not think that the Dollar will crash by one-third on the same logic that the 10 year Treasury has already arrested the fall of the dollar - relative yields among currencies. We are quite happy with our major predictions on the markets in the last twelve months.
We also think we will have seen the top of Bitcoin, which as Warren Buffett on a general reference to speculation put it : “If you risk something you need in order to gain something you don’t need, that is foolish. It’s just plain foolish.” Even if a US$57,000 price on bitcoin in not a top, that market has all the signs of a tulip mania when it becomes obvious that its many promoters don't even know what they are saying. It has no chance of becoming a medium of transactions just because it is a clever IT breakthrough of how blockchain and mining allow transactions to avoid "double spending", ie fraud.
US Treasury Secretary Janet Yellen's words last week are straight to the point - Bitcoin is an inefficient medium of transaction, and to this writer, those words refer to 1) the need for a network of computers run by a bitcoin mafia of miners rather than a government, and driven by lots of expensive and pollutive power to verify transactions even at today's low levels; and 2) a medium of exchange cannot by definition be volatile relative to all other media of exchange and the prices of goods. As such, the very promise of bitcoin is a false premise.
Can there be an eventual cryptocurrency that will replace paper or fiat money? Of course. But it will won't be Bitcoin. It may be the digital currencies based on fiat money that may be the best candidates. In short, an international digital currency that is acceptable to everybody on the planet will have to be backed by government, because nation states, each with a representative government, is how homo sapiens have chosen to organize society and civilization.
In the language of economists, a currency needs a lender of last resort, someone who can stand there to be counted when all hell breaks loose. In a non-government backed cryptocurrency, there is no such thing. It cannot work that way. For an IT technology, such as blockchain or even more powerful versions of cryptography and distributed computing to come, to become an end in itself is a pipedream. Technology is a great enabler, but it is not legitimacy itself.
Wai Cheong
Investment Committee
The writer has been in financial services for more than forty years. He graduated with First Class Honours in Economics and Statistics, winning a prize in 1976 for being top student for the whole university in his year. He also holds an MBA with Honors from the University of Chicago. He is a Chartered Financial Analyst.
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