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Post Fed market movements not a prelude to major risk-off

Late last week, the movement of cross assets were on a tear, triggered by more hawkish guidance from the US Federal Reserve, after its latest interest-rate hike projection has been brought forward by one year to 2023, while several Fed officials have pencilled in two projected Fed funds rate hikes before 2023.

To add fuel for the hawkish camp, prominent St Louis Fed president, James Bullard, conveyed his preference for an earlier interest rate hike to start in 2022 to contain higher inflationary pressures, during a media talk show interview on Friday.

The iShares MSCI All Country World Index ETF tumbled -2.15% last Friday. In contrast, the US dollar, represented by the US Dollar Index, has staged its best performance in 12 months, with an accumulated gain of +2.33% over a similar period. On the surface, one may view that a major risk-off scenario has just started, where a significant surge in US dollar strength tends to represent a demand to seek refuge in a safe-haven asset class, due to an impending liquidity crunch via anticipation of an earlier start to the interest-rate hike cycle. The earliest memory that market participants are likely to have anchored on will be the look-back period in late February 2020, where the US Dollar Index rallied significantly ahead of the carnage seen in global equities in March, triggered by the Covid-19 pandemic shock.

On the contrary, this time round may be different. Firstly, the Fed is likely to be playing mind games to tame future inflationary expectations. The five-year break-even inflation rate, a gauge of future expected inflation on average in the next five years, dropped by 10 basis points to 2.31% the day after FOMC meeting, and the break-even has been on downward trajectory since the 12 May high of 2.72%. If such inflationary expectations remain tamed and continue a downward trajectory, the Fed is unlikely to bring forward the start of its rate-hike cycle.

Source: Federal Reserve Bank of St Louis, data as at 21 Jun 2021, click to enlarge chart

Secondly, the movement across different sectors of the US stock market in the past two weeks is likely to be a rotation play unfolding ahead of the upcoming third quarter, instead of a broad based, risk-off scenario. Profit-taking activities outperformed cyclicals/value sectors in the first half of 2021 prior to last Wednesday’s FOMC meeting, due to narrowing yield spreads of longer-dated US treasuries over shorter-dated ones; the difference between the 10-year yield and the 2-year/5-year yields which has been unfolding since late May.

In addition, there seems to be lack of catalysts to push the reflationary theme play that has benefited cyclical/value stocks in the coming quarter, the additional $4 trillion US fiscal stimulus plan that has been pushed out by the Biden Administration has not been gaining much traction in Congress as we approach the summer months. In fact, the narrowing of the aforementioned US treasury yields spread reinforced by the latest Fed’s FOMC guidance has benefited higher quality technology stocks, which have overperformed cyclical/value stocks in the past three weeks.

These observations can be seen by comparing the average weekly returns across the current months of 2021 of the cyclical heavyweighted Dow Jones Industrial Average with the Nasdaq 100, which is heavily weighted towards big tech US stocks. This month, the performance of the Nasdaq 100 has improved significantly, notching an average weekly return of +0.83% versus almost zero returns in the first three months. In contrast, the significant positive weekly returns on the Dow Jones in Q1 have been wiped out, and the current average weekly return for June stands at -1.20%, its worst performance year to date.

Click to enlarge chart

Sources: Alpha Vantage, data as at 18 Jun 2021, click to enlarge chart

Thirdly, one of the key proxies to gauge risk-off/risk-on behaviour will be the performance of high-yield corporate bonds that have lower credit ratings. The SPDR Bloomberg Barclays High Yield Bond ETF (JNK) has recorded an average weekly gain of +0.22% so far in June, its best performance year-to-date, despite the strong movement in the US dollar in the latter part of last week. Also, the current outperformance of high-yield corporate bonds has surfaced despite the Fed starting to reduce the size of its corporate bond exchange-traded funds portfolio in March 2020, under an emergency-lending vehicle that was set up to provide a liquidity backstop for the financial markets during the Covid-19 economic fallout.

Source: Alpha Vantage, data as at 18 Jun 2021, click to enlarge chart

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