The stock market is on a tremendous, multiyear bull market, though of course there have been a lot of dips along the way.
But something seems to be different about the recent sell-off in stocks, which has pushed major indices down to levels not seen in August.
Just over a week ago, Dan Greenhaus of BTIG wrote this about the conversations he was having with clients:
What we find most interesting about the five session, 2.3% drop in equity prices, is not the shallowness of the decline, nor its length (or lack thereof). It was the speed at which sentiment shifted from bullishness to bearishness. Newspaper articles, television commentary and client interactions all appeared to shift on a dime, suggesting that perhaps, just maybe, people aren’t as comfortable in their bullishness as some may assert. We find this interesting given the table below which details exactly how positive the fourth quarter tends to be.
Why is this selloff causing such alarm? Or to put it another way, why is the selloff different this time?
The answer may be found in the interest rate environment.
To put it simply, there are signs all over the place that the market is anticipating monetary policy to tighten in the not-so-distant future, which is something we just haven’t seen in the post-financial crisis environment.
Here, for example, is a chart of 2-year interest rates. After years of grinding lower and lower, they’re now on a slow uptrend, which likely reflects the prospect of interest rate hikes in the cards sometime in 2015.
But that’s just part of the story.
Here’s a chart of 5-year real interest rates (real interest rates are calculated by taking interest rates on vanilla government bonds, and then adjusting for inflation). After years and years of declining real interest rates (meaning that inflation was running hotter than the nominal yield), now real interest rates are positive and appear to be trending higher. This is another sign of tightening monetary policy.
Another chart to check out is the 5-Year, 5-Year Forward Inflation Expectation Rate, which is the market’s expectation of what inflation will be over the coming years. As you can see, inflation expectations have been tanking lately.
This is ominous for the Fed as inflation expectations are starting to head towards levels below the Fed targets.
The upshot of all this is that monetary policy is tightening. Interest rates are rising. Real interest rates are positive and are rising. And inflation expectations are nosediving.
This is not what we’ve seen in previous market selloffs throughout this bull market.
The market is fearing a too-early tightening cycle that snuffs out inflation (and possibly the recovery) before it even has the chance to get anywhere.
In the past, markets could be soothed by the belief that any Fed tightening cycle was a long way out. Not anymore.
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