Stocks plunged Wednesday following news that the interest rate on the 2-year U.S. Treasury bond exceeded the interest rate on the 10-year bond. Since the 10-year is usually offered at a higher interest rate than the two-year bond, this represents an inversion of those two rates. This is considered a precursor to a recession by some economists. In fact, the past three occurrences of this indication (1989, 2000, and 2007) were followed by a market top of some kind one year later and a recession 18 months later.
The market panicked and sent major indexes down nearly 3% at one point during the session. Despite yesterday's concession-like news from the Trump administration and the subsequent market rally that followed, the previous session's gains were completely erased. This left the price action showing a decidedly strong line of resistance at the price level where the market closed yesterday.
For example, the S&P 500 (see chart below) shows a clear upward trendline since the post-Christmas lows in 2018. But in the past few trading days during what is seasonally considered a slow trading period for stocks, the index has broken its trendline and now twice failed to hold a close above it. Although yesterday's session was a strong rally, in reality it simply marks continuing volatility in the trading range. Unsurprisingly, today's action followed up with selling. The magnitude of the sell-off is notable, however, as the index closed near the lows for the past two weeks, setting up the possibility of a new downward trend in U.S. stocks.
Price action alone is not the only indication of this dour outlook. Volatility pricing confirms it. Consider the charts of the CBOE Volatility Index (VIX). These charts show that VIX futures are pricing in continued rising volatility over the next 30 to 90 days. That implies that traders are betting prices will be lower than they are now over the next one to three months.
Additionally, money manager behavior and international tensions all seem to be in concert. The forecast, at least for the short term, is for more volatile price activity, and that usually means falling prices will be the result.
Money Managers Running for Cover
When professional fund managers see signals of economic decline ahead, such as news of the 10-year and 2-year Treasury yields showing an inverted yield curve, they look for long-term strategies to keep their money safe. Most of them are not allowed to short stocks or buy futures and options to hedge their large portfolios, and they are only allowed to put a small percentage of the money in cash. That means they have to find stocks that they think will remain safe in a storm of falling prices.
Over the past century, the favorite sector to take cover in has been the utility sector. Utility stocks have low volatility and pay above-average dividends, so it makes sense that these would be considered safe-haven stocks. When these stocks are on the rise during a coincident period of falling stock prices in general, it is a good bet that money managers are fleeing to safety and taking cover in the utility sector. The chart below shows how this sector has fared since the start of the year. Unlike the rest of the market, most utility stocks have been on the rise over the past two weeks, some performing better than others.
Hong Kong Tensions Escalating Rapidly
Yesterday's session pushed stocks higher, supposedly on news that trade tensions were easing and perhaps that the U.S. and China might not continue on conflicting paths. However, despite a lack of new information on this front, markets began pricing in the possibility of a bad outcome. This is likely a response to the escalating tensions in Hong Kong, as mainland Chinese officials have made a show of force on the peninsula.
Comparing market index-based ETFs beginning with the iShares MSCI Hong Kong ETF (EWH), representing Hong Kong large-cap stocks, and also iShares China Large-Cap ETF (FXI), representing China large-cap stocks, it becomes clear that, since the start of 2019, the region's stocks have reversed fortunes. Though the mainland stock index has been falling with greater relative weakness over the summer, the Hong Kong index has declined more rapidly in recent days to close the gap and turn both indexes negative for the year, a signal of traders' diminished expectations for the outcome.
The Bottom Line
Although stocks rallied sharply Tuesday, they fell more rapidly on Wednesday, erasing gains and showing greater volatility. Traders and professional money managers both appear to be positioning for falling stock prices for a period of several weeks or more, based on money flows toward the utility sector and increased VIX and VIX futures measures. The U.S.-China trade conflict may also be influenced by the tensions in Hong Kong, which is as yet an undetermined outcome.
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