Stocks fall in spite of a partial late session reversal of heavy early losses. The S&P500 fell 1.2% to 1,859 while the Dow Jones fell 1.6% to 15,766. In spite of the seemingly large losses, today’s movements do not seem so bad considering the S&P touched an intraday low of 1,812 and the Dow was down as much as 500 points at one point. Falling oil prices contributed to the early selloff and accordingly energy sector stocks were a large drag on broader indices. WTI fell 6.7% to $26.76 and Brent crude fell 3.1% to $27.88. Iranian oil that is just now hitting the market after the trade restrictions were lifted is further depressing prices and weighing on sentiment. Currencies from oil exporting nations were losers today with the Russian ruble, Norwegian krone and Brazilian real all falling. The Canadian dollar gained 0.6% against the US counterpart as the Bank of Canada unexpectedly left interest rates unchanged, markets may had been expecting a rate cut. The 10 year US Treasury yield fell 4 basis points to 1.99% and the equivalent tenor bund lost 7 basis points to 0.48% as investors demanded haven assets.
The 5Y5Y forward inflation breakeven rate, one of the prominent market based inflation indicators, is showing that traders expect inflation levels to remain low well into the future. The rate is an indication of what markets expect five year inflation to be five years from now. It is calculated by looking at several Treasury securities. Some members of the Fed have suggested that they look at this gauge, and last week it reached 1.60% which is the lowest level since 2009. Critics of the gauge argue that it is too closely associated with short term market dynamics and that it may become a self fulfilling prophecy. Considering that expectations and sentiment play a role in future actual inflation, low expectations may in fact contribute to low realized inflation.
As investors demand haven assets the term premium on Treasuries is decreasing. The term premium is a measure of how much investors are compensated for going further out on the yield curve. In normal conditions investors receive higher yield for purchasing Treasuries with longer maturities but now given the panic in markets investors are willing to send the term premium lower as they expect uncertain conditions and low levels of inflation for prolonged periods of time. The term premium on the 10 year Treasury reached -0.12% last week compared to +0.14% two months ago. This indicates heightened levels of stress and negative sentiment in markets.
Interest rates in emerging markets have reached recent highs as risk aversion in global markets continues. Given market turbulence investors are unloading their riskiest positions and selling emerging markets positions, which has sent yields upwards. Currencies across the board have also weakened which is closely related to higher yields. Weaker currencies makes it more difficult to pay debts denominated in hard currency, increasing the risk of the investment. In the case of debt denominated in local currency weaker currencies reduce the relative value of payments if they are held by investors in foreign countries. Commodity prices falling intensifies this dynamic considering many emerging market governments and companies are dependent on commodity prices as a main source of revenue. According to an index from JP Morgan average yields on debt denominated in USD has risen from 5.3% last year to 6.7% currently. In especially exposed countries such as Ghana yields have risen from 8.41% to 15.10% on a 10 year bond. The IMF yesterday lowered its global growth forecasts for the next two years as a result of China’s slowdown and lower commodity prices both of which will negatively affect emerging markets. In recent years emerging markets both companies and governments had borrowed heavily as yields were low in the US and investors had appetite for higher yielding investments. Now with interest rates higher, this debt will be difficult if not impossible to refinance.