Stocks could see more volatility in the week ahead as the market continues to slug it out with bonds over rising interest rates.
Stocks come off a punishingly volatile week ready for more selling as the market continues to search for a floor and stock investors keep an eye on rising interest rates.
The S&P 500 was down 5.2 percent to 2,619, its worst week of trading since January 2016. The Dow, also off 5.2 percent, and the S&P both saw their first 10 percent correction since early 2016.
Culprits behind the selling were an ugly shakeout in funds that bet against market volatility and the building pressure of higher interest rates on stocks.
Treasury yields for the 10-year note and 30-year bond were slightly higher on the week, but the 2-year was lower at 2.05 percent. Rising yields pressured stocks, but when stocks sold off, investors turned to the Treasury market as a safe haven. That in turn sent rates back down, since yields move opposite price. The 10-year was at 2.85 percent Friday, below its 2.88 percent high for the week.
Despite extremely wide swings and days with 1,000-point Dow losses, stock strategists are mostly looking for the market to bottom soon and expect stocks will ultimately adjust to rising interest rates. But that process could be rocky, with many bond strategists now seeing the 10-year yield at 3 percent or above, much sooner than expected.
Bank of America Merrill Lynch chief investment strategist Michael Hartnett, who has long been looking for a correction, said he expects that a good buying level would be at about 2,500 on the S&P 500 and 3 percent on the 10-year yield.
„My gut here is 2,500 and 3 percent on the 10-year. They are big, big levels. You expect the market to find a reason to buy at that particular moment,“ he said.
The markets in the week ahead will focus on their own action, particularly the tensions between stocks and bonds, but there are a few key data points that could impact trading. The CPI, consumer price index, is released Wednesday and it is an important inflation reading that investors are watching for any surprise pickup in inflation. That is released Wednesday morning, as are January retail sales.
„The next big event we know that’s on the calendar is CPI, and that could impact the Fed. The next big date for the bond market after that, assuming stocks calm down, which is a shaky assumption, is the 28th, when [Fed chair Jerome] Powell testifies,“ said Michael Schumacher, director of rate strategy at Wells Fargo.
Powell started as Fed chair this past week, and markets have been anxious to hear his views on market volatility. Powell testifies before Congress Feb. 28, and the Fed is expected to raise rates at its next meeting in March. But market pros are watching the volatility, and there’s a view the Fed holds off on that hike if the turbulence persists.
Bond yields have been rising as global central banks, including the Fed, step back from easy policies and raise rates. Treasury yields have also been rising as investors eye the steep increase in U. S. Treasury issuance, expected to rise to $1.25 trillion this year. Another big catalyst for the market is the improvement in global growth and the potential for inflation to rise as a result.
Now the stock and bond markets are so closely correlated, the action in one feeds off the other. Stocks will be a big factor for bonds in the week ahead.
Gluskin Sheff and Associates‘ David Rosenberg said, in a note Friday, that the fact both stocks and bonds are selling off at the same time is unusual, and it is similar to time periods with significant market turmoil. He noted that the 10-year yield was rising as the S&P fell sharply Thursday, down more than 10 percent from its January record high.
„I cannot tell you how rare a market condition this is — that yields are rising into this risk pullback,“ he wrote in a note to clients Friday. Rosenberg cited how bonds rallied during the financial crisis in 2008 when the market fell and during other big corrections. Other times were 1987 and 1994.
As for currency markets, the U. S. dollar had a powerful week, with the dollar index rising 1.3 percent, its best week since October. As the dollar rose, oil fell, with West Texas Intermediate losing 9.9 percent for the week to just above $59.20 per barrel, its worst week in two years.
Hartnett expects a rising dollar and other de-risking moves will be necessary before the shakeout in stocks ends.
„Maybe we need to see the dollar move up, and that’s the thing that causes investors to do things they least like to do: sell winners — tech, high yield, emerging markets. In these corrections, you sell hubris and buy humiliation. One measure of humiliation is everything goes through the wringer. Nothing is left unscathed,“ he said. „The dollar rally would be the ultimate risk off. That’s part and parcel of the story.“
Earnings in the week ahead include consumer companies, such as Pepsi on Tuesday and Coca-Cola and Campbell Soup on Friday. Some energy names also report, such as Diamond Offshore on Monday and Occidental Petroleum on Tuesday.
JP Morgan strategists, in a late Friday note, said they believe that commodity trading advisors and risk parity hedge funds were at the core of the correction, but they believe that most of the unwind by those investors is over.
„This, combined with the low equity exposures of Discretionary Macro and Equity Long/Short hedge funds, leaves retail investors as the main residual risk for equity markets going forward,“ they wrote in a note.
Unlike in other corrections, many strategists said they did not see a fundamental reason behind the selling, and the market became hostage to big round technical numbers that seemed to drive trading. After breaking the 50- and 100-day moving averages, the S&P 500 bounced off the closely watched 200-day moving average Friday, at 2,538, and rebounded to close 1.5 percent higher.
„There’s a little bit of… technical activity around what is happening with volatility and how hedge funds have to readjust their strategies, given where volatility is,“ said Patrick Palfrey, equities strategist with Credit Suisse. „Going forward, we’re not really seeing a point where the economic cycle is coming to an end and with the earnings backdrop as strong as it is, volatility should come back in over the next couple of weeks, as people start to look more closely at those underlying factors.“
Hartnett said there were plenty of warnings the correction was coming.
„Certainly, the first tremors were the very rate-sensitive areas of the equity markets — utilities, the REITs, the homebuilders and bitcoin, which … reminded people of the famous phrase ‚fear of missing out.
