Are Stocks Headed for a Large Correction?

May 24, 2021 at 09:18 PM

Even though equity indices continue to be bought in lower prices, the nearest future still doesn’t look bright. 

The most important bond in the world US 10 Year Treasury has been in an obvious downtrend for 40 years. However, for the second time since 2018, the 10-year yield is breaking out from this downtrend and will possibly lead to higher yields over the next months. The yield on this bond represents the “risk-free” rate of return for the entire financial system. This is the level against which all risk assets – stocks, commodities, real estate, etc. – are priced and discounted. 

US 10 Year treasury yield broke out from downtrend and started going up in 2018. And it successfully managed to rise above the 3% threshold. It caused a quick decline in risk assets and resulted in a dramatic drop of the US equity indices circa 20% in just a few weeks. 

Then and now

However, what happened in 2018 and what is happening now are two different things. Back in 2018 the Fed was raising rates and shrinking its balance sheet – selling bonds it had bought in Quantitative Easing (QE) programs before 2018. And what is happening right now is that the Fed fund rate is at zero. The Fed has pledged not to raise rates for two years, and the central bank is growing its balance sheet by 125 billion USD per month with QE.

Back then, the Fed stepped in and stopped the balance sheet reduction. It is not clear how it will turn this time. 

High inflation and upcoming tightening

The core inflation is rising to 3%, which is the fastest pace of price growth since 1982. In addition to this, inflation is running lose. The Fed needs to start raising rates and taper its QE program soon to control rampaging inflation. 

Market participants expect the central bank to announce plans to taper QE in September, while the actual process is forecast to start in Spring 2022.

It already looks like both Nasdaq 100 index and Bitcoin are forming a large topping pattern. That’s because tech companies are easily affected by the higher yields and not in a positive way. 

It seems like all the stock markets became too expensive and due for a correction. And therefore 2018 may repeat itself if the Fed decides to tight monetary policy, which will result in equities blowback. Only this time, stocks are much more overvalued, inflation is higher, and the economic situation is much worse. 

Until then, the long-term trend might continue with investors buying declines. But as we said, it all depends on the Fed and how long it will take to start the tightening cycle. 

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