As we noted last week, the S&P 500 had fallen more than 10% in two days on April 3 and 4, one of the worst two-day declines ever. We also noted that fear and uncertainty was dominating the headlines and that any good news could spark a rally. Well, that happened last week.
President Trump put a pause on all reciprocal tariffs (excluding China) for 90 days and the S&P 500 responded by gaining 9.5% in one day, the third best single day since World War II. Like a beach ball under the water, once it gets some momentum, it can really start moving. In fact, we found 23 other times (since 1950) the S&P 500 gained more than 5% in one day and the future returns were quite impressive longer term, with stocks up a year later more than 91% of the time and up nearly 27% on average.
Just How Rare Was Wednesday?
It wasn’t just that Wednesday saw huge gains, it was that nearly all the volume on the NYSE was for stocks moving higher as well (something we call a buying thrust). In fact, advancing volume as a percentage of total volume came in at 98.6%, the most in history (using reliable data back to 1980). We found six other times that had extreme levels and the S&P 500 was higher 3-, 6-, and 12-months later every single time. This could be another clue that the sellers for currently known risks have exhausted themselves and higher prices over the intermediate term could be possible.
Another Near Bear Market
If you watched TV at all early last week, you likely heard how stocks were very close to a new bear market, meaning more than 20% off the February 19 peak. Intraday it did hit down 20%, but on a closing basis it only got to 18.9%, close but not quite there. Yet, for many investors heavy in technology, it sure likely felt like a bear market, with many of those names down much more than 20%. Here’s the thing — we’ve seen many near bear markets lately from a big picture perspective, including 1990, 1998, 2011, and 2018. All of those years had scary headlines and worries, yet managed to barely miss officially going into a bear market. We don’t know if this time will be added to this list, or if more trouble is around the corner and we are delaying the inevitable, but with the big rally on Wednesday and some historic levels of extreme sentiment, it is possible.
Bad Things Have Happened Before
If you’ve invested in equities the past seven weeks it hasn’t been very fun; we can likely agree there. At the same time, after more than a 70% rally from the October 2022 lows and not even a 10% correction last year, we were on record that a 10-15% correction was likely this year. No, we didn’t expect a near bear market with historic volatility, but we also (like many) didn’t expect tariffs to be as high and wide ranging as they have been either.
Here’s the thing, and it is important to remember. Bad times have happened before and they’ll happen again. The other thing to remember is stocks have eventually gotten past the bad news and weak market returns every time in the past and we don’t think this time will be any different.
Meltdown in the Bond Market
Treasury Secretary Scott Bessent has argued that even if the tariffs create a short-term economic slowdown and volatility in the stock market (check), that wouldn’t be too concerning since only the top 50% of households by income own stocks. (Note that this isn’t quite true, with lower income households owning anywhere from $2 – $3 trillion in stocks, which is not nothing). His main goal is to get long-term interest rates to fall, since that would help lower-income households who tend to have more debt service costs. (But keep in mind that an economic slowdown, or recession, wouldn’t be great for this group either because that could mean they lose their jobs.)
There’s also been an argument that this whole exercise of imposing massive tariffs is to reduce interest costs for the federal government, which has to refinance $9 trillion of debt next year. In reality, the federal government always has a lot of debt to refinance because it issues a lot of short-term debt (which all of us happily purchase, including in money market accounts). However, the interest rate on that depends heavily on short-term policy rates determined by the Federal Reserve (Fed). And if you want the Fed to cut rates, trade policy that sends inflation the wrong way would not be the way to do it.
In any case, we have a big problem on our hands. US Treasury interest rates are surging. The 10-year yield peaked Friday at 4.59%. It finished the week at 4.49%, which still is the highest level we’ve seen over the past month. On April 1, the day before “Liberation Day,” the 10-year yield was at 4.17%. It fell as low as 3.92% as stocks plunged, before surging more than 0.5%-points. That’s a massive move.
Is This China’s “Revenge”?
There are rumors that this was China’s “revenge,” i.e. that China is selling US Treasuries in retaliation for tariffs, pushing prices down and yields higher. But this is just pure speculation without even a hint of evidence in favor and some meaningful evidence against.
For one thing China does not own a lot of US Treasury debt anymore, just about $760 billion. Also, if they were selling US debt, they would be selling USD and buying yuan, in which case we’d see major appreciation in the yuan. That’s not happening right now — in fact, the opposite. The PBOC (China’s central bank) has actually been lowering the yuan reference rate. The yuan is now close to the lowest level in a decade and a half, with the PBOC carefully managing a gradual decline in their currency. Of course, this has the added effect of shielding the economy from tariffs, since it makes Chinese exports even cheaper for other countries (though they have a long way to go to overcome a 154% tariff).
A Dash for Cash
Instead, the rise in rates is likely due to portfolio managers at hedge funds liquidating positions. For one thing, “cash” (very short maturity Treasuries) is paying 4.3%, and so with the prospect of inflation (from tariffs), why would you want to take extra risk on long-term bonds? Market-implied inflation expectations over the next year (as measured by inflation swaps) have surged to almost 3.6%, which is the highest since mid-2022.
Several hedge fund strategies are also being unwound. There’s something called the “basis trade,” where funds use a ton of margin to take advantage of tiny difference in prices for Treasuries and associated futures. These are very small price differences and you need a huge amount of margin (about 50x) to make real money on it. Hedge funds were expecting Bessent to cut banking regulation this year, and one rule involved something called the “standard leverage ratio,” which makes it more expensive for banks to hold Treasury debt. These funds expected banks to start buying debt again and bet that Treasuries would outperform interest rate swaps (derivatives that are bets on yields). But because of tariffs, and rising inflation expectations, yields have risen, and banks are selling Treasuries instead. And so, interest rates swaps have outperformed Treasuries, forcing funds to delever (reduce margin) and unwind their positions. Oops.
The Fed’s Conundrum
A big part of what’s happening in bond land is the conundrum facing the Fed. Growth expectations are falling, best highlighted by crashing energy prices. WTI oil prices had plunged 20% to almost $56/barrel before rebounding to just over $60/barrel at the end of the week. At that price, we’re not going to get new drilling activity in the US, as oil producers need prices near $65/barrel to profitably dig new wells.
Lower growth expectations, or even a recession, should ordinarily lead one to expect the Fed to cut rates (and markets expect five cuts now in 2025). The problem is one-year inflation expectations, as noted above, have surged to 3.6%. That makes it very hard for the Fed to cut rates, even if inflation is “transitory.” In fact, Chicago Fed President, Austan Goolsbee, normally the most dovish member of the FOMC (the Fed’s rate setting committee), just expressed concerns that inflation could be persistently high for a while — that’s not good.
The market coming to terms with the possibility that the Fed may not cut rates as much as they expect (or at all) could be the next shoe to drop. Of course, if the Treasury market becomes disorderly, like in March 2020 when Treasuries sold off rapidly as funds deleveraged, the Fed may step in to provide liquidity. But that’s different from cutting rates and supporting the economy overall with lower rates, unless their actions are taken as “forward guidance” for upcoming rate cuts. Color us skeptical on that. Now, if the unemployment rate surges, say to 4.6%, we could see a rate cut, but that would mean the economy is in real trouble. In any case, the Fed is not going to cut rates until they see poor data, which means they’re going to be behind the curve.
A Weaker Dollar Creates Another Problem
One way to mitigate some of the inflationary impact of tariffs was a stronger dollar, as the current White House Chair of the Council of Economic Advisors, Stephen Miran, has suggested. However, given the magnitude of the tariffs, this was always going to have a minimal effect.
The problem is that the dollar has been going in the opposite direction. It’s been easing this year, with the dollar index down over 8% year to date, over half of that in April alone with less than half the month behind us. That’s not good, as it makes imports even more expensive.
When people ask me what’s the difference between an emerging market (EM) and developed market, we tell them that my market-oriented perspective is that a country is an EM if the following happens during a crisis:
- Stocks fall.
- Sovereign government bond yields rise.
- Currency falls.
We now have this exact environment in the US. Even in March 2020, as equities crashed, and Treasury yields rose briefly (before the Fed stepped in), the dollar was appreciating. That’s not the case now.
The only way to explain these moves is that investors, and the rest of the world, have lost confidence in America and are no longer flocking to the traditionally perceived safety of the US dollar and Treasuries. These now have a significantly higher risk premium and may no longer be “exceptional.” Increased global concern about US economic stability is slowly stripping the US of a source of a key economic edge for decades — cheap funding. That’s part of what’s making the stock market shaky. This is not to say markets won’t recover without further damage — they could, although we’re probably going to need more reversals from the White House for that.
The US had a generationally great deal with the rest of the world that has helped keep rates low for decades. It has been an important piece of American exceptionalism. Our currency was the most trusted. Our bonds were considered a safe haven in a storm, the “risk free asset” at short maturities. And those facts came with some significant economic advantages. That deal has been broken. A better deal could replace it or the old deal could be repaired, but the bar is high and the transition, even if something better is coming, won’t come without costs.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
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