Markets pivot 180 degrees as normality begins to take hold

Biden’s win and the Covid-19 vaccine breakthrough caused equities to rally and bond markets to question how long zero rates and QE will persist

The mood of equity investors has been buoyant, with new historic highs on the Dow and S&P 500, up 4.08 per cent and 2.16 per cent, respectively. AP Photo

Markets have undergone a 180-degree turn over the past fortnight, from being worried about the US election and a long winter of Covid-19 lockdowns to now seeing light on both of these fronts. This has resulted in a “reflation and normalcy” theme asserting itself, causing equity markets to rally and bond markets and money markets to question how long zero rates and endless quantitative easing will persist.

A fortnight ago, markets were concerned about the threat of a contested US election and were downbeat about the outlook for a global recovery in 2021 as they approached winter in the middle of a second Covid-19 wave. However, the point of maximum concern can often be the moment to think about more optimistic scenarios – and the past two weeks have been a good illustration of this.

Despite President Donald Trump’s rhetoric and tweets, the US election gave rise to a clear win for Joe Biden in the race for the White House. Coincidentally, within a few days of the result, the outlook for the coronavirus pandemic was also materially changed by the announcement that a Covid-19 vaccine appears to have been found.

Although there is still not complete clarity about either the US political picture (with no clear winner yet in the Senate) or the likely effectiveness of the Pfizer vaccine (which is said to be 90 per cent effective), there was certainly enough to produce a strong rally in equity markets to generate a “reflation and normalcy” theme.

Overall, the mood of equity investors was buoyant, with new historic highs on the Dow and S&P 500, up 4.08 per cent and 2.16 per cent, respectively. Some “Covid-19 stocks”, such as those in the technology space, experienced softness, accounting for the Nasdaq’s 0.55 per cent drop, but there were big gains in the sectors that had suffered as a result of the pandemic and associated lockdowns, such as travel and tourism as well as in pharmaceuticals.

The reaction in the US Treasury market was perhaps the most significant, with 10-year government bond yields pushing to as high as 0.97 per cent, the highest levels since March, with the two- to 10-year yield curve also steepening to its highest level since 2018 at one point. The Fed fund futures market started to think that the US central bank might even have to tighten earlier than expected.

A 50 per cent retracement from the lows would take the 10-year yield up to 1.13 per cent, which is now a target by many investors, but such a rally might run into difficulty if it reaches any higher, as the Fed might think more about adopting yield curve control.

The key fundamental question for bonds will be whether any uptick in growth arising from the vaccine gives rise to long-awaited inflation expectations. If that happens, the upside risk to bond yields might be hard for the Fed to control.

At the moment, US inflation pressures remain subdued as highlighted in the October Consumer Price Index report, with the headline rate at 1.1 per cent and core at 1.6 per cent, but there were some stirrings in producer prices on account of supply constraints. Any resumption of normality might be viewed as carrying inflation risks, but it is worth remembering that the “new normal” of the past 10 years has seen these threats largely absent.

Central bank chiefs were naturally more upbeat when speaking at the European Central Bank’s annual forum last week, while uttering some obligatory caution about the speed with which any vaccine-induced recovery could be expected to take hold. At the same time, they continue to put emphasis on the need for fiscal policy to exert a greater role in stabilising economies, something that might become difficult to achieve if US Congress is gridlocked.

Equity bulls might argue that gridlock means that the Fed will simply do more QE, but if the vaccine works, this may no longer be warranted. Indeed, if inflation rears its head, then all bets regarding further central bank support would be off, and a case would build for a larger re-pricing way beyond the modest “reflation and normalcy” trade seen so far.

Tim Fox is a prominent regional economist and financial market analyst.