Real Interest Rates, VIX Update, Powell

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Real Interest Rates, VIX Update, Powell

Published 10/4/21

Three “Data” items today:

#1: We do not think today represented a near term low for US equities or, by extension, global stocks. Why?

Our rationale is simple but based on decades of market history: the CBOE VIX Index only closed at 23. How can that be, given the S&P 500’s flirting with a down 2 percent day before staging a tepid and only grinding comeback into the close? The answer is that 3 sectors – Energy (our favorite group), Utilities and Real Estate – were up on the day and another 3 – Staples, Materials, and Industrials (another group we like) – were down just 0.5 percent or less.

In our experience, tradeable lows occur when there’s no “safe” sector to own and every industry group gets hit fairly equally. That, in turn, drives the VIX higher because it responds to actual volatility. If for example, every S&P group had been down roughly as much as Tech was today (-2.3 pct), then you would have seen a VIX close at 28-30 rather than just 23.

At the risk of repeating ourselves, because we’ve mentioned this recently, you want to see the VIX close at 28 before considering whether stocks are washed out enough to buy on a trading basis. That is one standard deviation (8) from the long run mean (20). And … The better opportunities lie when the VIX hits 36 (2 standard deviations) or 44 (3 standard deviations).

The chart below shows the VIX back to 2009, with the 1-, 2- and 3- standard deviation levels represented by the dark horizontal lines. This data shows why one must be cautious during bouts of market volatility. Sometimes markets form a near term bottom at or around 28, but 36 and 44 often follow soon after.

Takeaway: we continue to wait for the “fat pitch” of a genuine equity market washout before telling you it is safe to add to positions. The VIX says we are not there yet.

#2: A reader pinged us and asked for an update on US Treasury real interest rates. Now that nominal rates are see-sawing around the 1.5 percent level for 10-year Treasuries, has this begun to reset real rates? This chart shows the 5- and 10-year real Treasury yields in red and blue, respectively, based on prices for Treasury Inflation Protected Securities back to 2004.

Three points here that flesh out the comments inserted in the graph:

Real Treasury yields have been in secular decline since the early 2000s. An investor could get a positive 2 percent real yield on Treasuries before the Financial Crisis. Past 2010, however, real yields never got back to those levels. The best one could get was about 1 percent, and only briefly in 2018.

At present, real yields are the same as they were in Q4 2012, at -1.6 percent on 5-year TIPS and -0.9 percent on 10-year TIPS. That’s modestly less-bad than their worst post-Pandemic Recession levels of -1.9 percent for 5-years and -1.2 percent for 10-years. Real yields, in other words, are rising but only from unprecedently negative territory.

Real yields rebounded quickly during the 2013 “Taper Tantrum”. They turned positive 4 months after then-Fed Chair Bernanke’s May 22nd Congressional testimony that first mentioned the idea of tapering bond purchases.

Takeaway (1): just based on long-term trends, we’d say the days of positive real Treasury rates are likely over. In fairness, risk-free paper probably shouldn’t provide a positive real return. Long term Treasuries have done so for many decades, true. But … Demand for “safe” paper remains strong. And, aging US/developed economy demographics also argue for little to no excess yield above expected inflation as that cohort shifts capital to fixed income instruments.

Takeaway (2): if 2021/2022 proves to be a slow-motion replay of the 2013 Taper Tantrum and real yields go back to zero, then we can expect nominal 5- and 10-year Treasury yields to go to roughly 2.5 percent in the next 12-18 months. If that happens slowly, equity markets should be able to take it in stride. If it’s a fast move, perhaps driven by a series of still-high inflation reports, then we can certainly see it hurting stock prices.

#3: A quick update on Fed Chair Powell’s renomination odds. As we mentioned last night, Vice Chair Clarida’s personal trading disclosures were a “third strike” for the Federal Reserve’s reputation. No, nothing Kaplan, Rosengren or Clarida did went against Fed policy. But anyone who has worked on Wall Street (and both Kaplan and Clarida have) knows that the appearance of impropriety is the benchmark here, not a dusty rule book.

PredictIt odds for a Powell renomination stand at 66 percent on Monday evening, up slightly from Sunday’s 63 percent level but well off the +85 percent odds he enjoyed before the Kaplan/Rosengren news broke. Fed governor Brainard remains in second place, with 26 percent odds. Current Atlanta Fed president Bostic and former Fed Vice Chair Roger Ferguson are each at 5-6 percent odds. For what it’s worth, Ferguson’s odds spiked briefly over the weekend, to 18 percent, almost as if someone thought they had an inside line.

Takeaway: as our first Wall Street mentor often reminded us, “there’s never just one cockroach”, and the steady drip of bad news (with maybe more to come) out of the Fed makes us wonder if Chair Powell is “renominate-able”. Current odds say he is, but just barely. This is not the sort of setup that calms already jittery markets.

Sources:

PredictIt odds: https://www.predictit.org/markets/detail/7398/Whom-will-the-Senate-next-confirm-as-Chair-of-the-Federal-Reserve