February's Market Madness: Insights and Repercussions
February has always been a month of madness, and this year was no different as investors buckled up for a rough stretch. Strategists globally keened in on Fed Chairman Jerome Powell's rising interest rate comments, since U.S. Treasury yields have significant impacts on market volatility and asset prices worldwide. Following Powell's lax messages, shadows of uncertainty rose over U.S. markets as bond yields continued to run above 160 basis points (1.6%). Furthermore, the VIX volatility index, a barometer for future S&P performance, spiked by 60.9% at the end of January, indicating higher volatility and possibly negative stock index performance for the coming month. With the GameStop frenzy – a key driver behind the recent price volatility – coming to an end, a thorough fundamental analysis can help understand last month's turbulent markets.
Over the past month, the 10-year U.S. Treasury yield rose around 60 basis points. The key factor behind this rise is mass vaccine dissemination coupled with the $1.9 trillion Covid-19 relief bill's approval, boosting economic optimism and investor risk tolerance. As investors become less risk-averse, they begin to shift capital away from bonds and into equity in the hopes of generating a higher return. Yields rise when prices fall; thus, the decline in bond demand due to more risk and higher inflation expectations has led to lower bond prices and higher yields.
Presently, the Fed has been highly dovish, meaning lenient on interest rate regulation. Its leniency has caused uncertainty among investors' future yield projections. Fed Chairman Powell continued to downplay yield and inflation concerns throughout February – a significant reason behind the rise in yields. Jim Caron, head of Global Macro Strategies at Morgan Stanley, said that the leading cause of concern is the speed at which yields are rising. Usually, higher yields mean a more robust equity market. Still, there has only been a marginal impact on equities despite such a fast hike in rates. Further, Caron stated that another positive effect of higher yields should be a stronger U.S. dollar, yet there has been minimal appreciation on that front.
On the commodity side, oil prices have risen about 18% in the past month. Over the past five years, bond yields have tended to move in tandem with oil prices, which may indicate that oil prices may be a catalyst for yield upturn. This relationship makes sense since crude oil prices reflect world demand, and U.S. Treasury yields insinuate economic growth. Throughout February, oil prices floated above $60 and caused a lot of panic in the equity markets. Typically, an increase in oil prices leads to lower economic growth, greater inflation expectations, and dampening effects on stock prices. These surging bond yields and rising oil prices pressured scared investors to sell off risky assets such as prominent tech stocks, leading to a sharp 3.5% decline in the Nasdaq in February, its most significant sell-off since October 28, 2020.
Granted, despite the market correction, it is likely that global oil producers may begin to subside last month's hectic volatility. Unlike U.S. Treasuries, oil can be obtained from various countries with different political and economic motivations, ultimately leading to price distortions. Saudi Arabia, the de facto leader of OPEC, often causes these distortions to increase market share, decreasing crude oil prices. In 2015, Saudi's oil glut cascaded lower oil prices tremendously, which also lowered Treasury yields. Despite these drops, yields were not down to their implied values, as bond buyers knew this oil price shift was temporary due to Saudi's price distortions rather than an actual economic decline. Additionally, several other oil magnates globally, including OPEC+ members, have significant control over oil supply, which further amplifies yield shifts. So far into 2021, OPEC+ leaders, Russia and Kazakhstan, were the only ones who have marginally increased oil production. The remaining eight members have all either cut or left production flat, ultimately intensifying oil prices and bond yields.
Last month, Saudi's Paris Agreement supply restrictions sent oil prices surging. Although a severe accord, Saudi has been known to avert oil cutback promises, and we are likely to see this happening soon when the country does not meet its ESG goals. Furthermore, most nations are also failing to reach their emission level goals. The global coalition's combined impact is on a path to achieve less than 1% reduction by 2030, when its actual goal is around 45%. This fallback may further demotivate Saudi to make legitimate cutbacks, as it might ultimately increase supply and bring oil prices back down. Once again, when commodities revert to normal levels, Treasury yields may fall and finally settle down February's volatile episode.
Not only have yields and commodities overwhelmed markets, but technical analysis, the study of past market data, on February's returns exhibits consistent downturns. The S&P 500 index has faced flat or declining returns on average during February over the past 15 years. Moreover, countless macro factors further exacerbate the current volatile and uncertain conditions of the market. For one, the S&P 500 historically underperforms following a presidential transition, mainly due to the market having to adapt to the abolishment of past conventions and introducing new ones. When presidents change, investors are in the dark about commodity regulations, monetary policy, and spending bills, among others. Before official news is presented, this shift increases uncertainty, which provides immense volatility on stock markets. Beyond political influences, last month saw continued pandemic concerns as Covid-19 variants were on the rise and relief bills were still in talks. At the start of February, the VIX rose 11.18 points to just above 31, its largest spike since June.
Recently, continued economic growth and rising inflation projections have further bumped bond yields past February numbers, causing skittish U.S. stock markets to remain unsettled and tech stock prices to stagnate. Although the Fed has provided little substance to long-term rates, it has remained sanguine due to the underlying cause of rising yields. Typically, as Powell notes in his recent presser, a rebounding economy coupled with increasing inflation does not warrant monetary policy in the short term. Specifically, U.S. GDP forecasts have been off the charts, as the Bank of America expects 8%, 11%, and 5% GDP growth from Q2 to Q4, respectively. In contrast, the average U.S. GDP growth of all quarters since 1961 has been a little over 3%. Powell hopes to allow this organic growth to continue by incorporating minimal government intervention for the time being.
All in all, it seems as though we are headed for another bull run, as Powell has quietly noted that he expects to keep interest rates low for the foreseeable future. These comments – in conjunction with stock market stabilization from the settling of the short squeeze pandemonium and February's adverse macro effects on the markets – have calmed the VIX and investors. Finally, suppose Saudi does pull back from its original Paris Agreement goals. In that case, we will also see oil prices fall and ultimately compel a bullish stock market once again.