Weekly Fundamental Report – May 2, 2018 by Ramy Abouzaid

By Ramy Abouzaid, Head of Market Research at ATFX

In the past week and over the weeks ahead, the markets’ focus is on the yield curve for US bonds, especially the 10-year Treasury following its breach of the closely watched 3% mark, its first time since the first quarter of 2014.  We saw a quick response from the US stock market with declines despite better than expected quarterly results of major US companies.

S&P 500 Index

The Standard & Poor’s 500 Index closed at 2669.91 recording a decline during last week’s trading after opening the week at 2675.40. This is the limited change in the S&P 500’s movement for the second week in a row. For example,

Google, Facebook, Twitter, Amazon, Caterpillar, and all these big names came out with quarterly earnings beating expectations.

Despite the above, we did not see a clear reflection of the movements of the indices of stock markets, which constitute an important part of the composition mentioned above, but on the contrary the index began trading last week on declines during the first two days of the week and returned to compensate for those declines last Thursday and Friday. This was accompanied by a limited rise with a decline in the bond yield curve.

Curve yield on ten-year bonds:

The yield curve upward move has generally indicated that markets are not buying bonds, preferring to inject liquidity into other risky assets such as equities and others. As shown in the graph above, the yield on 10-year bonds is moving above 3%, The stock markets are threatened for two reasons. Firstly, the break of 3% levels and their stability above these levels give the markets a signal that the current bullish trend in yields is continuing. This makes traders question the level of returns that would pose a real risk to equity markets.

In other words, what is the level of return that will be a real temptation for investment managers to shift from riskier assets to fixed income instruments?

Once you raise these liabilities by tapping the yield curve to the highest level in the last four years, this in itself is a pressure factor on equity markets. Obviously, we do not need to remind you of the impact of the US market indices on the global stock markets.

Why do markets care about the yield curve and are more sensitive to its highs than before?

To answer this question, we must first remember that previous gains in the yield curve were accompanied by a more accommodative monetary policy by interest rates that were historically near zero levels, as well as the bond buying program that was implemented by the US Fed. Of course, a higher rate of return was more directly controlled by direct intervention than open market operations, the mechanism by which the Fed was applying its asset purchase program, and thus the markets were more comfortable because there is a major player who adjusted the curve. As for the reasons behind this concern and the sensitivity of the markets, I will refer to three points which in my opinion are the most important behind it:

First, the continued rise in US bond yields threatens the attractiveness of other assets:

Yes, we admit that the average yield on US bonds is still more attractive, but so far, over the last ten years, if we calculate the average return on the S&P 500 we will find it at around 7.30% per year. If inflation is considered, this makes the question of the levels that will be indicative of the attractiveness of investing in equity markets a very logical question: What incentivizes me as an investment manager to invest money in equity markets to get a yield of around 7% annually? And how long can I spend 3% on my investments without exposure?

Second, continued high bond yields may prompt the Fed to further raise interest rates:

As bond yields continue to rise, the gap between the federal rate of return and the federal interest rate increases, which may be a factor driving the US Federal Reserve to accelerate federal interest rates in an attempt to reduce the gap. This will increase the overall cost of financing in the United States, which will naturally affect investment spending, rates, and growth in general.

Third, the difference between ten-year bond yields and two-year bond yields declined:

The continued rise in bond yields was accompanied by a significant decline in the difference between 10-year bond yields and two-year bond yields, signaling that ten-year bonds still outperform the two-year bonds and are yielding more, which means that markets still have some long-term concern even if they have some sort of short-term confidence.

Weekly Economic Calendar

This week begins with holidays in many markets due to the annual celebration of Workers ‘Day in most of the countries and Showa Day in Japan, but this is accompanied by data from China including its Industrial PMI, which is expected to be about 0.2 lower than the previous reading, according to the average of analysts’ expectations.

From China to Australia, where markets are waiting for the Reserve Bank of Australia’s interest rate decision, which is not expected to make major changes to its monetary policy during the meeting, according to the reading of previous monetary policy data and the country’s inflation data not improving.

From the UK, where its PMI is expected to be released on May 1 and is expected to see some decline, according to the median forecast of analysts.

From the US, the Manufacturing PMI is expected to be released.

However, Wednesday remains the hottest day of the week as the monetary policy decision is expected to be released from the US Federal Reserve, which is expected to see no change in interest rates. However, it is likely to come with new signals that the markets are expecting a rate hike at future meetings later this year.

This Friday, we are expected to see the reading of the US labor market data, where the jobs report in the private sector is expected to improve after the disappointing reading during last month’s report, but reading the average change in wages is the most important reading.

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