New Century's Biggest "Bull Trap"? US Bond Yields and the US Dollar "Take Off Together," US Stocks May Fall Another 9%!

The S&P 500 index rebounded last week due to a drop in US bond yields and a weaker US dollar. However, Michael Kramer, the founder of asset management firm Mott Capital Management, pointed out that the bear market rally may fade after a series of economic data releases this week, causing the S&P 500 index to continue its decline and resume the pullback seen in August, potentially dropping by 9% from last Friday's closing price and reaching 4100 points in the coming months.

Kramer stated that the rebound from mid-March to mid-July was one of the most incredible bull market traps since the Nasdaq 100 index surged 43% in the summer of 2000. It was a trap driven by the illusion of cooling inflation, allowing the Federal Reserve to cut interest rates and loosen monetary policy as the US economy slid towards a soft landing. Although there may be some early signs of economic softening, it is still too strong and resilient to prompt the Federal Reserve to change its expected path of restrictive monetary policy.

The "anchor of global asset pricing" dances, putting immense pressure on US stocks

The US stock market has once again returned to the situation of "bad news is good news" as traders believe that once there are signs of significant economic slowdown, the Federal Reserve will step in to rescue the stock market. The "bad news brings good news" trend started on August 23, when the weak preliminary August PMI data for Europe and the US released on that day significantly lowered nominal interest rates. Then, over the past week, weaker job openings data (JOLTS) and lower-than-expected "small non-farm" - ADP employment figures (although the July data was revised significantly upward) once again led to a decline in interest rates. However, last Thursday, as expected, core personal consumption expenditure (PCE) data and hot (excluding housing) core PCE services inflation data helped stabilize interest rates, which then rose after the stronger-than-expected non-farm payroll data and the stronger-than-expected August ISM manufacturing PMI data in the US on last Friday.

While there have been some signs of economic slowdown in the US, overall, the economy remains strong, indicating that the market may continue the previous trend of pushing up long-term interest rates and buying back the US dollar. After all, economic models such as the Atlanta Fed GDPNow and Bloomberg Nowcast show that the actual GDP expectations for the third quarter have hardly changed after the release of a large amount of data. According to the latest data, the Atlanta Fed's GDPNow model predicts that the US GDP in the third quarter will reach 5.9%, previously estimated at 5.8%.

This indicates that the yields on 10-year and 30-year US Treasury bonds will continue to rise and may even surpass the upper end of the range set before the drop on August 23.

Overall, due to several economic data in the US performing better than market expectations recently, even the slowing data is not as bad as feared, intensifying people's bets that the Federal Reserve will maintain higher interest rates for a longer period of time. This data has largely stimulated the 10-year US Treasury bond yield, known as the "anchor of global asset pricing," and the US dollar index has also risen in response. At the same time, some Federal Reserve policymakers insist that inflation needs to be brought below target and that there is more work to be done. San Francisco Fed President Daly stated that the latest inflation data does not mean that the central bank can declare victory over inflation, and added that the labor market is not yet balanced.

Secondly, the recent surge in natural gas and crude oil prices also highlights the significant risks of inflation rebound in the United States, while the surge in US Treasury bond issuance is also putting pressure on the bond market. In addition, with Japan raising the tolerance range for its Yield Curve Control (YCC) policy, the expectation of a large amount of funds flowing back to the domestic bond market in Japan is increasing. These factors have led to a rapid increase in long-term US bond yields (maturities of 10 years and above) in recent days.

Generally, there is usually a certain degree of positive correlation between the 10-year US Treasury bond yield and the US dollar. This means that when the 10-year US Treasury bond yield rises, the real yield tends to increase as well, and the US dollar exchange rate will also rise, and vice versa. This relationship is mainly due to the yield differentials caused by interest rates and the impact of capital flows.

The strength of the US dollar is unstoppable, posing an additional risk to US stocks

In addition, strong US economic data will continue to support the US dollar. The US dollar index regained all lost ground after the release of better-than-expected non-farm payroll data. From a technical perspective, the US dollar index may rise to around 106 in the short term and eventually to around 111.

Moreover, in the past two months, expectations of a soft landing for the US economy have increased, and inflation expectations have also started to rise. However, concerns about a recession in Europe have begun to emerge. Despite the poor economic data and downward revision of non-farm payrolls in the US this Wednesday, the European data is even worse, and the initial jobless claims in the US continue to decline. These resonating factors have contributed to the relentless rebound of the US dollar. In addition to the weak euro, the other two major global safe-haven currencies have also been in a downward trend against the US dollar, which has provided some degree of support to the dollar.

Previously, strategists from banks such as Credit Suisse and Barclays had warned that if the Swiss National Bank slows down or even stops buying Swiss francs in the foreign exchange market, the strength of the franc may have peaked. Traders and speculators are also increasingly bearish on the franc. Erik Nelson, a macro strategist at Credit Suisse in London, said, "As the Swiss National Bank becomes less aggressive in buying its own currency and selling the franc becomes more attractive, we will see the franc gradually reach its peak. It makes sense for long-term asset management companies to sell the franc at high levels."

Swiss National Bank President Thomas Jordan said in June that the restrictive financial environment would have a "dampening effect," which for Nelson is an early signal that policymakers may start to relax their foreign exchange interventions. Previously, the Swiss National Bank took unprecedented tightening measures, selling over 60 billion Swiss francs (equivalent to 68.6 billion US dollars) of international reserves from the second quarter of 2022 to the first quarter of 2023 to boost the domestic currency and reduce its balance sheet. These measures helped bring the inflation rate down to 1.6% in July, although policymakers predict that price pressures will re-emerge.

Now, Wall Street strategists are beginning to doubt how long Swiss National Bank officials will continue to support the franc. Data from the US Commodity Futures Trading Commission (CFTC) for the week ending August 8th showed that speculators' net short positions on the franc have increased more than tenfold since the end of May. At the same time, data from Deutsche Bank shows that institutional investors' short positions on the franc have reached one of the highest levels in the past five years.

According to Lefteris Farmakis, a foreign exchange strategist at Barclays, as inflation has returned to the official target range, officials' direct support for the franc is nearing its end. He said, "The franc has become a bit too expensive, and now the demand for the Swiss National Bank to buy francs has greatly decreased." Farmakis attributes the recent rise in the franc to concerns among safe-haven investors about the deterioration of economic data in the eurozone, stating that the franc is "unlikely to appreciate due to active foreign exchange interventions."

In addition to the franc, another major safe-haven currency, the yen, has also faced significant depreciation pressure recently. As the Federal Reserve and other central banks raise interest rates, Japan has adopted loose monetary policies, which have put downward pressure on the yen, making it the worst-performing currency among the G10 countries this year. The market had originally expected the yen to strengthen, but due to the cautious stance of the new governor of the Bank of Japan, the yen's upward momentum has not materialized, disappointing hopes for more substantial action by the Bank of Japan. At the same time, the display of weak economic data has increased the pressure for the yen to depreciate.

Last month, the USD/JPY exchange rate broke through the 145 level for the first time since November 2022. It is understood that since the Bank of Japan adjusted its yield curve control policy at the end of July, the yen has been steadily weakening, and the yield on 10-year Japanese government bonds has reached its highest level in 9 years.

Nevertheless, the Bank of Japan still indicates that it will maintain its current monetary easing policy, while the United States is exploring further interest rate hikes. The soaring hedging costs mean that the yen selling at the end of the month is unlikely to stop soon. Win Thin, Global Head of Currency Strategy at Brown Brothers Harriman & Co., wrote, "As the Bank of Japan remains dovish, we expect the USD/JPY to eventually approach 150. The fundamental factors continue to favor the US dollar."

Toyoaki Nakamura, a board member of the Bank of Japan, also stated last Thursday that it is still too early to tighten monetary policy, as the recent rise in inflation is mainly driven by rising import costs rather than wage increases. Nakamura said, "It will take a long time to sustainably and stably achieve a 2% inflation rate. Therefore, we need more time before turning to a monetary tightening policy."

Japan's negative interest rate policy and other factors that hinder the appreciation of the yen have led strategists at Goldman Sachs and JPMorgan to take a more pessimistic stance on the yen. Goldman Sachs stated that if the Bank of Japan maintains its dovish stance, the yen is expected to fall to levels not seen in over 30 years. In the next six months, the USD/JPY exchange rate is expected to reach 155, the lowest level since June 1990. Their previous forecast was 135.

Moreover, some Wall Street traders are betting that US interest rates will remain higher than inflation for a long time, which will drive the exchange rates of the US dollar against some major currencies to new highs. HSBC Bank stated that there is a "new factor" supporting the US dollar, namely concerns about the US budget deficit and the supply of government bonds, which have led to higher long-term US government bond yields. Therefore, under the influence of these factors, other major safe-haven currencies are facing depreciation pressure, and the US dollar seems to have a strong upward momentum.

Many investors are not aware of the importance of the US dollar to the stock market, nor are they aware of the impact of a strong dollar on stock prices. The appreciation of the dollar has reduced the competitiveness of US export products overseas and weakened income and profit growth. Additionally, it tightens the financial environment and eliminates leverage in the financial system. The total assets and liabilities of G5 central banks denominated in dollars, including the People's Bank of China, have been declining, partly due to the strength of the dollar. Over time, this liquidity has become highly correlated with the S&P 500 index, making it extremely important, and recent deviations have been astonishing.

This poses a problem for stock market investors: the perception that significant fluctuations like those on August 29th indicate that everything is clear and that the worst pullback in August is over. However, the rise in the S&P 500 index on Tuesday was driven by a weak dollar, declining interest rates, and the positioning of the options market, resulting in a negative gamma zone in the stock market. This dynamic created a large-scale rebound as traders had to buy when the index rose, but this rebound may retreat in the coming days.

Another important factor is the recent surge in oil prices, which have risen to $86 per barrel, meaning that as gasoline prices rise, CPI swap pricing has pushed up inflation expectations for the next few months. CPI expectations for August have risen to 3.6%, September to 3.4%, and October to 3%. Considering the inflation rate at this time last year, these figures may not seem significant. However, these CPI expectations will only rise if oil prices continue to climb. The longer overall inflation stays above the Fed's 2% target, the longer the Fed will have to maintain higher interest rates, and the greater the risk that the Fed will need to take further action.

Conclusion

Complicating matters is the fact that the rebound in almost the entire stock market has been driven by multiple expansion rather than fundamental improvements, as the P/E ratio of the S&P 500 index has risen from around 18.1 on March 24th to around 20.8 on September 1st. If the price-earnings ratio of the index (with an expected earnings of $217.26 in 2023) falls to 18.1, the index will drop to 3930 points. And this is related to the issue of the US dollar, as the rise in the price-earnings ratio is mainly driven by the relaxation of the financial environment, which is directly related to the depreciation of the US dollar. Therefore, if the US dollar continues to strengthen, this should lead to further multiple contractions. A stronger US dollar may also cause overall profit decline for the constituents of the S&P 500 index, due to adverse foreign exchange factors.

High interest rates, a stronger US dollar, and rising energy prices may make the US stock market more challenging for the remainder of this year. As prices fall to lower levels and the financial environment tightens, this could lead to the S&P 500 index returning to 4100 points in the coming months. Ultimately, this will depend more on the subsequent developments, revealing the importance of fundamentals and macro trends to the surprise of the bulls.