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Why Stocks Are Down In October

In short, stocks are down largely because rates have been climbing. To some extent, forward earnings expectations have compressed slightly. But that’s not the main reason, so this post will focus on the rates aspect.

Why have rates been climbing to the extent that they have? 

Rates started going up at the beginning of Q4 (three months left in the year) because the cross-currency swap basis began widening. (For more background on cross-currency swaps, this gives a good overview.)                 

Non-US banks have unstable sources of USD funding and want to lock in financing by year-end. International dollar funding is unstable because about half of is comprised of less reliable funding sources, including swaps and interbank/other money market lending, as opposed to more stable sources such as deposits and bonds. 

This also increases risks in the Eurodollar market, which by a sizable margin is the largest international funding source. Its creation was a form of regulatory circumvention given it’s a funding source not under the authority of the US Federal Reserve or any government agency. 

The Eurodollar always trades at a premium to Treasuries because the former contains some level of credit risk, while Treasuries are largely the lowest credit risk instruments globally. The Eurodollar and USD LIBOR markets track each other tightly.                           

The widening of the cross-currency basis reduces international demand for US Treasuries.

Why?

Because when the cross-currency basis widens, the cost of hedging US Treasury holdings gets more expensive. Foreign buyers will thus have less of an inclination to buy them or own them. Prices go down and yields increase.

Stocks get knocked in tandem through the conduit of:

1. Higher discounting rates at which the present value of future cash flows is calculated and

2. Bonds becoming a more competitive source of returns relative to equities

Throughout 2018, a euro-hedged 10-year Treasury bond holding yielded 0-40 bps. At the beginning of the quarter, this dipped from 20 bps down to minus-15 bps (a difference of 35 bps).

For a yen-hedged 10-year Treasury bond, this yielded 0-60 bps. At the beginning of the quarter this dipped from 40 bps down to minus-10 bps (a difference of 50 bps).

When EUR and JPY funded sources of Treasuries buying result in effective differences of 35-50 bps of yield, this will materially crimp demand for these instruments.

Last year, this didn’t happen until December because dollars weren’t as scarce then as they are now. In 2018, the Federal Reserve has taken additional steps to remove liquidity from the financial system through a combination of raising the fed funds rate (FFR) and interest on excess reserves (IOER), and by running off its balance sheet.

FFR 

Another very important point:

The FFR is also holding toward the upper bound of its current 2.00%-2.25% range at 2.19% rather than at its 2.125% midpoint. 6.5 bps may not seem like much, but it is not immaterial.

The math is such that if you were to get a parallel 6.5-bp rise of the yield curve the price of stocks would decline by about 1.4%.

The Fed’s inability to keep it at the midpoint is due to a couple main reasons:

1. Increasing Treasury issuance from the federal government’s fiscal deficit is driving up rates on interbank money market lending (repurchase agreements or “repos”). The main lenders in the fed funds markets are Federal Home Loan Banks, which were established by Congress to help support the US housing finance. To this point, the FHLB system largely had not used its cash for repos.

However, as repos yield higher rates, FHLBs view these instruments as increasingly attractive investments and lending in the fed funds market provides an opportunity to negotiate for higher rates.

2. The Fed’s other form of monetary policy, balance sheet tapering (also known as “quantitative tightening”), has caused a reduction in bank reserves. These initially topped out in October 2014 when the Fed officially ended its quantitative easing program.

The increasing scarcity of bank reserves slows the pace of credit creation, holding all else equal, and can drive up the cost of money market rates, include the FFR.

IOER


Fed Balance Sheet  

The Fed, starting this month (October), runs off $30 billion per month (its maximum scheduled), up from $24 billion per month previously.  

Conclusion

When non-US banks have unstable sources of dollar financing they will be motivated to lock in rates because most global financial transactions are conducted in US dollars as the world’s reserve currency. This will have the effect of widening the cross-currency basis.

This effect will be temporary. Therefore, its influence and spillover into credit and equity markets will also be temporary and should mediate after the new year. 

Despite strong demand for dollars, the cross-currency basis does not remain elevated over long periods of time due to arbitraging activity assuming:

1. The US money markets and FX swap markets are not segmented and

2. Counterparty credit risks are assumed to be minimal between banks and other lenders

When the cross-currency basis widens, one institution can earn a risk-free profit by borrowing in USD in the money market and providing it as a funding source in the FX swap market. If enough of this activity takes place, the cross-currency basis will converge back to zero.

This will have the effect of making hedging costs in the US Treasury market less expensive. This increases foreign buyers’ demand for US Treasuries (the opposite of what’s happened). Holding all else equal, this increases the price of Treasuries and lowers their yields. Through discounting and bonds becoming less attractive as a competing investment to equities, stocks rise in price.  

Accordingly, you can expect this dip in stocks as a direct consequence of the cross-currency basis widening to flow out of the market by January.

With that said, with a slowing economy over the next 2-3 years as the fiscal stimulus rolls off, this will compress earnings. At the same time, the Fed is fairly aggressively hiking short-term rates, which will bleed into other money and credit markets, and naturally be a headwind to equities markets as well.

2019 will mark an increasingly vulnerable and volatile environment for stocks and lesser-quality credit as liquidity is increasingly pulled out of the financial system.

Credit will continue to become increasingly attractive relative to equities, with a preference for short duration over long duration and higher quality credit over lower quality. If you have not yet begun the process of reducing your exposure to equities, now would be a good time to do so.