Markets get no helping hand from the Fed

Make no mistake, there are two forces driving financial markets this week. Firstly, the Federal Reserve in the US, secondly Opec, the oil cartel. Both have dramatically influenced markets as we move towards the end of the week. When markets are defined by these forces, other things don’t seem to matter – for example, a decent earnings season and economic data. When markets are moved by forces that tend to operate in financial markets with broad brush strokes, the day-to-day movement of prices can be volatile. Thus, as we move towards the end of the first quarter of this year (with 3 weeks to go), the only asset that we predict to move higher in a straight line is volatility, in particular the Vix index, which measures volatility in the S&P 500. 

What the Nasdaq does next 

This may sound like a flippant remark, but there is some method to the madness. Let’s look at the Nasdaq Composite index. This time last week, the Nasdaq had fallen sharply because of a surge in Treasury yields. US bond yields surged because Fed chair Powell had not been vociferous in trying to talk yields down during a testimony to Congress. This week is like Deja vous. The financial world waited with bated breath for Fed chair Powell to speak at a jobs conference this afternoon. During the speech, while he continued to sound dovish, he offered nothing to cool the sharp rise in bond yields. The result was another bout of volatility on a Thursday, US 10-year Treasury yields jumped nearly 10 basis points to just under 1.55%, which is the highest level for more than a year. US stock indices declined sharply, with the biggest losses reserved for the tech-heavy Nasdaq Composite, which is down some 1.7% at the time of writing. The rising yields/ sell off in tech stock theme is unlikely to go away anytime soon. The reason is that for many tech stocks future cash flows are determined by the discount rate – a lower discount rate (interest rate) = a higher cash flow, a rising discount rate = a lower future cash flow. When future cash flows are negatively impacted by rising yields, the stock market panics, and equity prices decline. 

This is bad news for some tech companies. For example, Uber’s share price is down some 5% on Thursday, and it has fallen more than the broader market. However, Amazon is down less than 0.5%, Facebook is up more than 1.3%, and even relative Nasdaq newbies like Snowflake and DoorDash are higher. There was a point earlier in the session where the Nasdaq looked like it may be about to erase gains for the year so far, however, it managed to bounce off of these lows. This brings us to another point about the tech stock sell off. Not all tech stocks will fall at the same rate, you need to choose the stocks that you are bearish about carefully. The reason is that the surge in tech stocks in 2020 was partly down to falling global bond yields, and partly down to other structural factors, such as the digitalisation of the world in which we live, which is unlikely to change. Thus, companies like Amazon have become more powerful during this pandemic, so it is likely to out-perform a company like Uber, which has been badly hit by the pandemic. So, you need to do your research before you embark on a tech trade. 

A deep dive into the tech sector 

An example of the disparity in the tech sector, DoorDash, which listed on the stock market to much fanfare last year, is up nearly 1% so far today on the back of news in the UK that Deliveroo plans to list on the FTSE 100 with a valuation estimated at $10bn. This is not bad for a food delivery service. The switch to broad-based food delivery services across the world is one of the changes that we expect to be structural, thus these companies could be immune to the threat of rising bond yields, for now. In contrast, Tesla’s share price is down nearly 6% at the time of the writing.  This is partly to do with rising bond yields – this makes purchasing expensive cars like Tesla’s less attractive for the general public, but it is also because of two factors that are Tesla specific. The first is growing competition in the EV space, which could erode Tesla market share. The second is that a bulk of Tesla’s earnings comes from selling regulatory credits that offset a company’s carbon production. Tesla has a lot of these credits to sell, more than $300mn last year, while other companies have needed to buy them to off-set the gas-guzzlers that they produce. However, if these car companies reduce the amount of gas guzzlers that they produce, and instead start producing EVs, then they will start accumulating more carbon credits, Tesla won’t be able to sell their credits as easily, which could destroy a lucrative source of cash flow. Hence, we would prefer DoorDash to Tesla for the long term. 

Where next for yields? 

Back to the Fed, the Nasdaq tried to recover towards the end of the US session, but it failed, while 10-year US Treasury yields remain at 1.54%. This is precariously close to our line in the sand of 1.6%. However, before we all rush to thinking that yields will continue their steep ascent and that inflation is out of the bottle, it is worth putting the rise in Treasury yields into some context. The move to 1.54% is roughly where 10-year Treasury yields were before the pandemic took hold of financial markets. This is to be expected, now that we have a vaccine, and the prospect of the end of coronavirus and economic recovery is in sight. However, Friday’s unemployment report is interesting. NFPs are expected to come in at 182k, but we had a weaker than expected ADP report and initial jobless claims were higher last week compared to the week previous, which might suggest a weaker than expected jobs number. A slower employment recovery means a dovish Fed for the long term, which means that a weaker than expected NFP report on Friday could stop yields in their tracks before they get much passed 1.6%. While a stronger payrolls report means a break above 1.6% in the 10-year Treasury yield is possible, and this could weigh further on stocks. 

The UK Budget: prospects are bright 

Elsewhere, the UK Budget had something for everyone: a rising tax burden but not for a few years to come, a brighter economic outlook, an extension of the furlough scheme which could keep unemployment at bay, and confidence that the UK can get its debt under control. Rising bond yields are a worry, but not a big one for the chancellor. While rising yields will push up the cost of servicing the UK’s debt, far more important is the speed of economic recovery and the UK’s growth prospects, which actually look quite bright. This compares with Europe, where the economic outlook remains dark, it remains mired in the Covid crisis because of its slow vaccine rollout and rising bond yields are compounding the problem. Rising yields in Europe combined with weak growth prospects are a terrible mix, which is why we are bearish on EUR/GBP for the long term. 

And a word on oil…

Back to oil, it’s rising because Opec said that it wouldn’t reverse production cuts, thus propping up the price. Brent is up by 5% to mor than $67 per barrel, the only way seems to be up, and while we expect some stickiness around $70 per barrel in the coming days, we ultimately expect this resistance level to be broken also.