China has a long holiday, and the overseas market will always make some "unitary". The US government has just avoided a "shutdown" crisis, and the market has not yet taken a breath; The long-term US bond yield has soared continuously, and it has become the "unbearable weight" of the global market, and stocks and bonds have fallen across the board. To sum up the performance of the overseas market in a single word - "chaos", not only the asset price performance is "sad" (Figure 1), but the logic behind the asset is also confused (Figure 2).
We believe the combination of overseas market performance during the holiday season is unsustainable and may reflect a liquidity shock disconnected from economic fundamentals. Through the performance of assets before and after the holidays, we believe that the logic of "exchange rate depreciation - selling US bonds to obtain a stable exchange rate of the US dollar - US bond yields rise" may be questionable. On the contrary, China's potential role as an important provider of global dollar liquidity should not be ignored by markets - without China, global dollar liquidity could become even more stretched in the context of Fed tightening. There are reasons to believe that as the holiday season ends, global markets will gradually return to normal logic. The logic of the late cycle rebound in the United States (late cycle rebound) + the Fed will not easily turn (higher for longer) + global manufacturing bottoming recovery, the dollar will be the first to peak, but it will take time for long-end US Treasury yields to turn, and US stocks are relatively volatile.
On a fundamental level, the broad decline in global markets over the holidays (with the exception of the dollar) is puzzling. This perplexity manifests itself in at least three ways: First, the surge in long-end US bond yields (the 10-year US bond yield once stood at 4.8%) led to a significant narrowing of the inverted term spread (10Y-2Y). Historically, the main trigger for the US bond term spread to turn upward was the Fed's interest rate cut expectations (resulting in a decline in short-end interest rates). Part of that was the reflation trade (November 2016) or the fear of ending QE (May 2013), while there is no expectation that the Fed will shift to lower interest rates and the market's inflation expectations are stable. On the basic level, the rise in real interest rates may reflect more of an economic "non-landing" (Figures 3 and 4);
Second, US stocks and commodities did fall sharply at the same time, reflecting more signals of a sharp economic slowdown or even recession, which is inconsistent with the first point.
Third, the combination of rising real interest rates and stable inflation expectations is compatible with a rising dollar index, but a sustained rise in the dollar index is incompatible with a recovery in global manufacturing (Figure 5).
If we look beyond the fundamental framework of growth-inflation, much of the problem can be explained from the liquidity dimension. From the point of view of asset prices, the general decline of global assets (including gold), the rise of real interest rates and the rise of the US dollar index are often related to the liquidity situation of the global dollar, and the extreme situation can be referred to March 2020 (the only difference is that the Federal Reserve did not significantly cut interest rates).
From the perspective of liquidity mechanism, after the epidemic, especially after the Fed entered the tightening cycle, the global dollar liquidity environment has changed. China is playing an increasingly important role in the global dollar liquidity (Figure 6-7). On the one hand, through the "clean" trade surplus after the epidemic, China's banking system and enterprises have accumulated a large amount of dollars;
On the other hand, there are at least three important channels through which China exports dollars to the world: Chinese outbound investment, outflows of foreign capital from Chinese markets, and swap purchases (the equivalent of short-term dollars in the market) to stabilize the yuan. As Figure 7 shows, after the Fed entered the tightening cycle, foreign capital outflows from China were supported by other emerging markets, while China's extended holiday left an important link missing in global liquidity transmission (Figure 8).
However, it is worth noting that compared with last November, there is an important difference in the global liquidity environment this year. Last year, because of the pension crisis at the end of September, the Bank of England temporarily "restarted QE", easing the market's tightening concerns, and this year, the Bank of Japan to further relax the YCC restrictions, JGB yield rise expectations, to the already reduced liquidity of the market "fire."
Based on the above logic, we believe that after the end of the long holiday, the market will gradually return to normal: on the one hand, the recovery of the Chinese market, on the other hand, the Bank of Japan will not change the YCC policy in the short term simply because the yen has fulfilled the market's expectations. We expect that overseas, especially the United States, is still the logic of late cycle rebound, the Federal Reserve will not easily turn higher for longer, and the global manufacturing industry will bottom out and recover, the dollar will be the first to peak, and commodities will still have a better performance. But the decline in long-end Treasury yields will take time, and U.S. stocks are relatively volatile. Specifically:
From a seasonal perspective, the US stock market and US debt may have fallen enough in September, but it does not mean that October can come to an end. Historically, US stocks generally fell in September, and US bond yields generally rose from September to October, with the average decline of US stocks at about 1% and the average increase of US bond interest rates reaching 35bps (Figures 9 and 10). U.S. stocks fell nearly 5 percent in September, a steeper decline than their historical average. On the other hand, if interest rates do not rise enough in September, they will rise in October. From the current point of view, September US bond yields recorded a large rise in the relative resilience of the economy, and the room for further rises in October is limited.
But obviously seasonality is not the main reason for pushing up US bond yields, the more critical thing is that the US economy and policies do not let up, and "bottom-diving funds" dare not easily enter:
The hawks and pigeons of the Federal Reserve have a unified tone, and interest rates continue to be "higher for longer." One of the important reasons for this surge in US bond rates is that the dovish Fed officials, who have always been moderate, have also sent signals that high interest rates will remain for longer. Bostic made it clear that there was little urgency to cut rates and that it was appropriate to keep them on hold for an extended period of time. Superposition, as always, the "eagle" sent Mester's speech, pushing the US long bond interest rate to brush a new high in nearly a decade.
The core of this argument lies in the signs of a "re-recovery" in the US economy:
The wave of strikes in the automotive, film and other industries had a limited impact on employment, which is directly reflected in the number of job vacancies in August: the vacancy rate rose from 5.4% to 5.8% in August, combined with a low voluntary turnover rate, which will trigger wage "re-inflation" (Figures 11 and 12). Thus, the resilience of the labor market remains an upside threat to inflation.
The global manufacturing industry has come out of the bottom range, and the accumulation of three signals has released the confidence of the manufacturing industry. Sweden's manufacturing PMI as the leading global manufacturing PMI, new orders and inventory index ratio rose for four consecutive months; In addition, although the current global manufacturing PMI is still in the contraction range, new orders, output and new exports are steadily moving toward 50; Similarly, a rise above 50 in the future output index indicates an improvement in growth expectations (Figures 13 and 14).
Us manufacturing, in particular, is sending more positive signals. The manufacturing PMI, which came in significantly better than expected in September, contracted at its slowest pace in almost a year. With production picking up and employment rebounding, the U.S. manufacturing sector has taken another step toward recovery. This is consistent with the positive signal from the global manufacturing PMI.
The possibility of US debt breaking 5%? Not small. In the case of the number of interest rate hikes is basically determined, the key to whether the 10-year US Treasury interest rate can break 5 in the short term is when the policy will be loosened. At present, the center of the federal funds rate this year may reach between 5.5% and 5.75%, the current market expects the rate cut next year to be around 60bp, and the top of the 10-year US Treasury yield may be near 5%, but it is necessary to be wary of the current prominent contradiction between supply and demand will cause short-term overshooting of US Treasury yields (Figures 15 and 16).
Although the US stock market has certain valuation pressure, the high scale of cash holdings and the psychology of retail investors to buy on the low may make the fall of the US stock market not smooth. The interest rate environment plus rising labor, borrowing, and energy costs weakening corporate profitability could put mean resetting pressure on U.S. stock valuations. However, according to the results of Bank of America's September investment survey, cash holdings accounted for about 4.9% of total assets, which is at the upper edge of the normal range (4% to 5%). On top of that, retail investors are much more active in the stock market than before. According to a recent Gallup poll, the percentage of Americans investing in stocks rose from 55 percent in 2019 to 61 percent in 2023, the highest level since the global financial crisis, These groups are deeply rooted in the concept of AI and the "Big Seven" (Amazon, Microsoft, Apple, Google, Nvidia, Meta, Tesla) to buy the dips (Figures 17 and 18).
Of course, there could also be an unexpected scenario in which Treasury yields stay high for a long time or even continue to rise, leading to risks for financial institutions. Such a scenario could force the central bank to resume expanding its balance sheet while keeping interest rates high, similar to what happened after the Silicon Valley bank collapse in March, creating better conditions for the stock market, particularly growth stocks, such as the Nasdaq.
Risk warning: global inflation rises beyond expectations, the US economy enters a significant recession ahead of schedule, the Russia-Ukraine conflict situation is out of control resulting in sharp fluctuations in commodity prices, the policy is forced to turn ahead of schedule, and the US banking crisis is again exposed to financial risks.