Market Update: June 28, 2016


Information derived from

Market Update

Stocks, oil reverse course. Global equities are taking a breather from the steep selling pressure over the last two days as U.S. markets rise in tandem with WTI crude oil, which is finding support around its 50-day moving average, and European indexes, which are up 2-3% across the board. Today’s action comes on the heels of a second day of declines on Monday that left the S&P 500 down another 1.8%, as materials and financials continued to lead the retreat. Overnight, Asian markets recovered from a rocky start; the Nikkei Index closed near flat and China’s Shanghai Composite gained 0.6%. Elsewhere, safe-haven assets are slipping as the yield on the 10-year note ticks higher after closing yesterday at 1.44%, and COMEX gold pulls back from its recent highs.

Macro View

Treasury rally continues post-Brexit vote. The flight-to-safety trade was still in effect on Monday, as yields fell across the curve. In addition to the economic uncertainty, the vote likely keeps central banks, particularly the Federal Reserve Bank (Fed) and Bank of England (BOE) more market-friendly for longer. Expectations for the BOE are shifting toward a rate cut and possible restart of bond purchases. Over the past two days, the yield on the 10-year Treasury declined over 0.30%, from 1.74% to 1.44%. Looking back to the beginning of 1962, a move this extreme over two days has occurred during less than 0.75% of all trading days–highlighting the rarity of such a sharp and swift move.

History suggests high-quality bonds may hold gains over the near term. A look back at prior market shock events such as Lehman, the flash crash, the debt downgrade, the collapse of LTCM, and the 9/11 terrorist attacks shows that Treasuries generally hold onto safe-haven gains over the coming 1-3 months following a shock event. Despite the sharp move lower in Treasury yields and even more expensive valuations, a reversal is unlikely soon, if history is any guide. We discuss in more detail in this week’s Bond Market Perspectives. In the meantime, the 10-year Treasury yield at yesterday’s close level of 1.44% is just above the all-time low of 1.39%, reached on July 24, 2012, and the 30-year Treasury yield is within striking distance of the February 2016 all-time low.

Fed rate hikes turn to rate cut expectations. Near-term rate cut expectations increased on Monday, with futures pricing showing a nearly 25% probability of a rate cut at the September or November Fed meeting. Another 0.25% rate hike is not fully priced in until early 2018. Market expectations of the future path of interest rates had started to move lower in recent weeks, but Brexit has accelerated the more market-friendly Fed view and supports the lower for longer theme.

High-yield spreads back above 6% post-Brexit. As is typical during bouts of flight-to-safety buying, lower-rated bonds such as high-yield, bank loans, and preferred securities lagged high-quality counterparts. The average high-yield bond spread, based on the Barclays High Yield Index, closed Monday at 6.4%, with the average yield of the index back above 7.5%. Considering year-to-date gains and valuations that are only fair in our opinion, recent weakness does not create a buying opportunity and the sector continues to have a tight correlation with oil, which poses a risk if dollar strength continues.

Municipals keep pace with Treasuries. Municipal bonds rallied along with other high-quality bonds during Friday’s flight to safety, and the Barclays Municipal Bond Index gained 0.4% for the week. Municipal bond almost matched the strength of Treasury gains one-for-one, which is rare during bouts of flight-to-safety buying. As a result, average 10- and 30-year AAA municipal-to-Treasury yield ratios remained on the expensive side of recent ranges, at 88% and 90%, respectively. Average AAA municipal yields closed at new all-time lows on Monday.

Home prices suggest solid housing market–no boom, no bust. The Case-Shiller Home Price Index posted a 5.0% year-over-year increase in April, the same increase as in March, keeping home prices largely in-line with income growth, which has been running between 4.5-5%. This data point–along with others on home prices, sales, and construction released over the past month–continues to suggest that housing is adding to gross domestic product (GDP) growth here in 2016, as it has since 2011.

The data dilemma: pre-Brexit versus post-Brexit data. Today’s data for home prices are for April, and as such, do not reflect any changes to the market post-Brexit. This pre-Brexit versus post-Brexit theme in the data will be in place over the next several months, as investors gauge what (if any) impact Brexit has had on the U.S. economy. Data released over the rest of this week (June vehicle sales and June Institute for Supply Management [ISM]) both fall into the pre-Brexit bucket, as will the June jobs report due out on July 8. The weekly initial claims data should be watched closely, and the first real post-Brexit data point will be the July Purchasing Managers’ Index (PMI) data, due in the third week of July.

Worst two days since August 2015. The S&P 500 dropped another 1.8% yesterday on the heels of a 3.6% drop on Friday, for a two-day decline of 5.4%. That is the largest two-day drop since late August 2015. Technically, the S&P 500 closed beneath its 200-day moving average for the first time since March as well. The real interesting action was in the CBOE Volatility Index (VIX). The “fear gauge,” as it is well known, dropped 7.4% yesterday, even as the S&P 500 dropped nearly 2%. Incredibly, since 1990, only once has the S&P 500 dropped more on a similar VIX implosion and that was during the Iraq invasion of Kuwait in August 1990.

What happens after a big drop on a Friday? The S&P 500 has dropped more than 3% on a Friday 10 total times since 2000, including last week’s drop. As we noted in the After Market Call on Friday and on Twitter over the weekend, Monday tends to be rather weak after a big drop on Friday. That trend played out yesterday; today on the LPL Research blog we will take a closer look at this development and see what happens each day of the week after a 3% drop on Friday.