Waiting for the Fed to interpret the bond market and why negative real yields are good for equities

The Federal Reserve 2-day meeting that starts this Tuesday and concludes on Wednesday could not come at a better time for investors. On Monday the 10-year real Treasury yield sunk to -1.27%, when adjusted for inflation, which suggests that bond investors are dramatically losing faith in the outlook for economic growth and the prospect for Fed tapering its asset purchases any time soon. 2-year nominal Treasury yields, which are closely linked to near term interest rate expectations, are also down some 6 basis points in the last month to 0.22%. Even though corporate earnings remain strong, equity markets are at record highs and there are signs that the latest Covid wave in the UK, that is dominated by the Delta variant, has peaked and is now receding, the bond market remains wary, but why? 

China’s crackdown on middle class parents 

There was a risk off tone to financial markets at the start of the week, which was largely down to heavy losses in Asia. The Hang Seng sunk more than 4%, while the Shanghai Composite was down some 2.5%. this came on the back of yet another Chinese regulatory crackdown, this time focusing on the education sector. $2 bn of Chinese stocks were sold on Monday, as the market tried to make sense of the latest Chinese regulatory rule for private companies which now bans tuition groups from making profits, raising capital or going public. The aim of the new rules is to “reduce students’ academic burden and household spending on the fiercely competitive university entrance examination system. Ultimately, this is a way to even the playing field, with tuition companies more likely to benefit middle class families, and is a deeply populist move akin to Brexit, Donald Trump etc in other parts of the world. 

The political landscape in China is shifting, gone are the days where greed is good and corporate profits only went to those at the top. Beijing is using its political might to avoid the fate of Brexit in the UK and inter-class problems in the US to deal with what the average Joe sees as inequalities right now. If you are an investor in Chinese stocks, take note, and potentially shift your money to more capitalist-friendly countries in the region, including Japan, where the Nikkei rose more than 1% as Chinese indices fell sharply. 

Why European bank earnings could boost the FTSE 100 

European indices were mixed at the start of the week, the German index was down 0.25% at the time of writing, while the UK index rose a mere 0.15%. This is largely because Europe is more closely tied to the US, where we await the Fed meeting, and also some key European corporate earnings. This week the media focus is on big tech earnings in the US, however, here at Minerva Analysis we are looking at the European banking sector that will release key quarterly and half year earnings results later this week. Like their US counterparts, the European banking sector is expected to pare back loan loss reserves as a result of fewer bad loans during the course of this pandemic. However, whereas in the US the big 10 banks have “written back” close to 75% of loan loss provisions, in Europe the stance is much more cautious. The loan loss write backs are expected to only amount to 25% in Q2, with further write backs expected in the coming quarters, Covid permitting. I will leave it up to the individual trader to decide if European banks are too cautious, and if they acted more like their American counterparts then they might have seen a stronger recovery rally than they currently have done, with UK banks and European banks up some 11% and 16% since late last year, well below the performance of American banks. 

Investors will be looking for guidance on the strength of share buybacks and dividends, which the UK and the Swiss have allowed in recent months, while the ECB gave banks the green light to restart share buybacks and dividends on Friday. The extent and scale of these will likely determine how well European banks’ stock prices will do in the short term. We expect the best news to come from some of the big European names such as Société General and BNP Paribas. Credit Suisse is likely to have a bad quarter due to loan write downs linked to Archegos Capital and Greensill Capital from earlier this year. UK banks could play catch up with their European counterparts as the Eurozone economic recovery seems far shakier than the UK’s right now, and UK retail banks including Lloyds and NatWest could benefit from a boom in the mortgage market on the back of a strong UK housing sector. 

The Fed meeting: what happens when money has nowhere else to go…

Back to the Fed meeting that concludes on Wednesday, the market is not expecting any strong guidance about when it will taper its $120bn per month of asset purchases, and this meeting is unlikely to provide any major policy shock. What it may reinforce is that the Fed is split on when to taper asset purchases. Although Jerome Powell is an uber-dove right now, there are others who are likely to dissent from this view. Ultimately, we think that Powell will steer this week’s Fed meeting to kick the tapering can further down the road, especially with the Jackson Hole symposium coming up next month. We continue to think that Treasury yields will remain subdued, largely because the idea of a future with global economic stagflation has embedded itself into the market psyche right now partly due to the resurgence of the Delta covid variant. This is important for stock traders, as it means that real Treasury yields (when adjusted for inflation), are likely to remain deep in negative territory for some time. When that happens, traders look for higher yielding assets such as equities and lower quality corporate loans. This is why we expect equity markets to remain bid in the coming days, with stocks linked to economic growth doing well in the short term, including those lagging UK banks!