A market in suspense

Good morning. The People’s Bank of China stepped up its defence of the Renminbi yesterday, after the Chinese currency slid to its lowest level since 2023. The PBoC said it would sell Rmb60bn ($8.2bn) of bills in Hong Kong in January, its largest sale since auctions began there in 2018. Chinese authorities have pledged to keep the currency stable. But with China’s struggles, and the US’s strong economy, that may take serious firepower. What is China prepared to do? Email us: [email protected] and [email protected].

Maximum uncertainty

Something significant has shifted in markets in the past month or so. We can all feel it. What exactly is it? 

The change is perceptible in all corners of the market. But let’s start with equities. In the months running up to the election, US stocks were ticking upwards by fits and starts. Immediately after the election, they got a big boost, with small-cap — that is, riskier — stocks getting the best of it:

The fun did not last. Around the end of November, small caps started to fall, and big caps started to trade sideways rather than up. Rates pretty clearly have something to do with it. Here is small caps plotted against the 10-year Treasury yield:

After the boost from the election results, the smalls got a second leg up from the drop in yields a month or so later. When they pushed back up in late December, the whole stock rally reversed.

That’s a simple enough story: higher rates are bad for stocks. But of course higher rates are not always bad for stocks. So what kind of rate increase is this? And why don’t equities like it?

One explanation that will not work: the idea that inflation is bad for stocks, and investors became convinced that the Fed is set to let inflation run out of control. Nominal Treasury yields can be decomposed into real rates (for which inflation-protected Treasury yields are a proxy) and inflation expectations, or “break-evens” (the nominal yield minus the inflation protected yield). And it is the real yield, not break-evens, that have done most of the work in pushing up nominal yields: 

See more : Australian share market falls after a broad-based sell-off on Wall Street — as it happened

That said, the market has come to think the Fed is going to have to lean a bit harder into inflation. The expected reduction in the policy rate has grown smaller and smaller:

The expectation that rates will stay higher for longer goes part of the way to explaining the rise in yields, but not all the way. This is visible in the fact that the long end of the curve has risen more than the rate policy-sensitive short end. The gap between the two-year yield and the ten-year yield has risen quickly since the end of November:

This steepening of the yield curve is explained, in large part, by a rising term premium. The term premium is the extra yield that investors in long-term bonds demand, in addition to the expected path of short-term rates. It is extra compensation for locking in for the longer term; in other words, a margin of safety.

Why the term premium moves around is always the subject of debate. But in the current case, I think the increase in the premium is pretty clearly attributable to Treasury investors not knowing what the heck to expect from the economy, monetary policy or the market. Consider another shift that happened at the end of November in the stock market. Along with all the shifts in the bond market at that moment, we saw small caps start to underperform large caps, the S&P 500 equal weight start to underperform the capitalisation-weighted index, and investors flee value stocks in favour of growth:

Why do those shifts indicate a rise in uncertainty? Because they are all driven by a move to the stocks that have worked in recent years, or the stocks currently perceived as the safest bet: large-cap US growth, primarily the Big Tech oligopolies. Shifting to big growth is the new form conservative investing.

The big change in the stock market, then, is not driven by a particular narrative about the economy, the trajectory of earnings or the direction of capital flows. It is driven by the lack of a clear narrative. Whether this is down entirely to the political transition taking place in the US is open to question. It does seem, however, that the incoming president’s policy of strategic ambiguity is hard for the market to process.

Every moment feels uncertain while you are living it. There is reason to believe this moment actually is more perplexing than most.

A question for readers on stablecoins

Over the holidays, stablecoin issuer Tether made the news when the big crypto trading platform Coinbase announced that, for regulatory reasons, it would restrict traders in the EU from buying Tether’s coins. The market cap (number of coins in circulation multiplied by their value) of Tether’s USDT, the world’s largest stablecoin by a mile, fell a bit, and other stablecoins perked up on the news:

All this left us with a question, which we pose to you: what is the market’s ongoing use case for stablecoins? Specifically, will stablecoins like Tether have an important role to play in cryptocurrency trading as crypto becomes more mainstream, more liquid and better integrated with fiat finance? Why use stablecoins to buy other cryptocurrencies? We don’t use an intermediary to trade stocks, bonds, currencies, gold, grain or real estate. Why should crypto be different?

(We are sceptics about crypto for economic and philosophical reasons, but we are not experts on the mechanics. If we miss a technical point in what follows, email us). 

See more : Dow, S&P 500, Nasdaq slide as government shutdown looms, inflation data improves but still sticky

Stablecoins are crypto assets pegged to fiat currencies. The idea at their inception was to ease transactions between fiat currencies and volatile cryptocurrencies by having a stable, digital token representative of a dollar on an exchange. As Tim Massad, former director of the Commodities and Futures Trading Commission put it to us, they are “on-chain cash”.

For Tether and its competitors, this is a great business. According to Tether, every coin it issues is backed up one to one with fiat reserves, typically parked in short-term US Treasuries, like a money-market fund. But money market funds are paying between 4 per cent and 5 per cent right now; when a user buys a Tether coin, they don’t get that yield — Tether does. Essentially, the stablecoin issuers are harvesting returns on the users’ fiat (plus transaction fees!) in return for holding the cash and issuing the token. There is a lot of economic friction here. 

Tether and other stablecoins have another purpose, of course. As accessible assets pegged to the dollar, they “liberalise” dollar access and ease global transfers. They are becoming an unbanked, unregulated, dollar-based payment system. That sounds OK to us, though we think the coins will have a tough time competing against fiat currencies and other cash-transmission tools — except among people who are keen to avoid regulation and detection.

But on the crypto trading side, we are perplexed. Crypto backers are desperate for regulators to endorse the asset class and integrate it into the traditional financial system. If cryptocurrencies become easier to hold, whether that is through a 401(k) or a run-of-the-mill brokerage account, why continue to use stablecoins? Wouldn’t it become as easy to use dollars to buy crypto? Is there a friction between fiat currencies and cryptocurrencies that stablecoins would still solve? Let us know.

(Reiter)

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