To The Moon

Recently, the global financial market has experienced great fluctuations, and US stocks have turned downward again since mid-October, continuing the downward trend since the end of July. As of October 24th, the S&P 500 index of the United States has dropped by 7.8% compared with the high set on July 27th, and the Nasdaq index, which is sensitive to monetary policy, has dropped by more than 9%.

The U.S. economy also shows strong resilience, because the original high interest rate environment will obviously cool down the U.S. economy. However, due to the negative impact of fiscal expansion on liquidity contraction caused by quantitative tightening (QT) and credit contraction caused by high interest rates, the liquidity of the U.S. dollar has not converged significantly.

Looking ahead to the market outlook, the special combination of high interest rates, high inflation and high leverage (fiscal expansion) is unsustainable, and the subsequent US fiscal expansion is difficult to maintain. From August to September, US fiscal expenditure has begun to shrink. On the one hand, the US economy is facing great downward pressure in the fourth quarter, and downward profits pose pressure on US stocks; On the other hand, due to the lack of fiscal expansion hedging, liquidity tightening will also pose a major challenge to US stocks.

The resilience of American economy and stock market comes from fiscal expansion

Looking back at the global economy in the first three quarters of 2023, the US economy is obviously better than expected. The recession worried by the market at the beginning of the year did not appear, and it is possible to achieve a "soft landing", but it is also possible to enter a "no landing" state where inflation is difficult to fall back.

From the historical experience, during the monetary tightening cycle, the US economy will fall into recession most of the time, and US stocks will fall at a large level. Why is the US economy and US stocks resilient in this round of tightening cycle? We think there are mainly the following aspects:

First of all, the crisis of American commercial banks in March caused the Federal Reserve to suspend quantitative tightening (QT) for a time, and the Federal Reserve also introduced an emergency financing tool of Bank Term Financing Plan (BTFP), which provided a lot of liquidity for the market. BTFP program allows banks to use US debt and institutional mortgage-backed securities as collateral, and can provide loans with a maturity of up to one year. In the week ending September 27th, the bank's time financing plan (BTFP) financing loans reached 107.7 billion US dollars.

Secondly, at the time of the Federal Reserve's rate hike and quantitative tightening, the US fiscal expenditure increased significantly, which offset the liquidity contraction brought by monetary tightening. To some extent, the US government hopes to suppress inflation through monetary tightening such as rate hike, but it is unwilling to have a recession. From the perspective of American money supply, the year-on-year growth rates of American money supply M1 and M2 have been negative for eight consecutive months, and they decreased by 0.5% and 0.1% respectively in September.

The sharp decline in the size of the Fed's balance sheet means that the liquidity released by the Fed through asset purchases has shrunk sharply. Data show that the QT (Quantitative Tightening) implemented in the United States since 2022 has greatly reduced the balance sheet size of the Federal Reserve, which fell to 7.4 trillion US dollars in the week of October 18, and the peak in the same period last year exceeded 9 trillion US dollars.

However, American finance expanded obviously from January to August. The U.S. fiscal deficit is financed by short-term treasury bills, and almost no long-term bonds are issued, so the U.S. economy enjoys the benefits of widening fiscal deficits (that is, the residential sector has obtained funds) without being pressured by rising yields. The data shows that from May to June, the year-on-year growth rate of US fiscal expenditure increased by more than double digits, and the year-on-year decline from August to September was more than 30%; And from May to July, the fiscal deficit remained above $2 billion. Annual, the US fiscal deficit has accounted for more than 5% of GDP for three consecutive years.

Rising short-term US bond yields put pressure on US stocks

Different from the past, the surge in US bond yields is not driven by strong economic growth or rate hike expectations, but by the term premium and the imbalance between supply and demand of US debt, instead, it is an unfavorable way to the economy.

One of the characteristics of this round of US bond yield surge is that compared with the rapid upward trend of long-term interest rate, the trend of short-term interest rate is relatively stable, and the larger upward range of long-term interest rate compared with short-term interest rate drives the US bond yield curve to steep again. On October 23rd, the upside-down range of the most representative 10-year-2-year term spread converged from 108bp in early July to 19bp, with a range of 89bp.

Where does the driving force for the rising term premium come from? Mainly from the credit crisis of US debt, both domestic and overseas institutional investors are worried about the risk of US debt.

Since the end of May last year, the liquidity of the United States has faced severe downward pressure, both in the narrow sense of banking liquidity and in the broad sense of liquidity. The amount of the US Treasury's public account (TGA) in the Federal Reserve has increased, the Federal Reserve's shrinking balance sheet and credit creation have been weak, the US banking industry has continuously reduced its bonds and the US banking industry has deposited deposits to money market funds.

Credit contraction may continue to exert pressure on US stocks in the fourth quarter

The Federal Reserve can't see the possibility of cutting interest rates for the time being. On October 19th, Federal Reserve Chairman Powell delivered a speech at the New York Economic Club, saying that the inflation data in the United States has cooled down this summer, and inflation is still too high anyway, so the road to fighting inflation may be bumpy and take some time.

From the perspective of credit expansion, the US dollar credit index we constructed shows that the US dollar credit contraction is very obvious in the financial market.

US dollar credit expansion is divided into domestic and overseas, and overseas expansion is mainly realized by foreign trade deficit and holding net international position, both of which have obvious convergence. High interest rates inhibit private sector investment and consumption in China. In the week ending October 11th, the growth rates of industrial and commercial loans, real estate mortgage loans and consumer loans dropped to 0.2%, 5.7% and 4.6% respectively, and the growth rates in the same period last year were all above 10%. Considering the continuous sharp reduction of US finance since August and the McKinsey incident, this means that both parties in the US Congress are willing to continue to maintain fiscal expansion.

To sum up, with the rise of bond yields, the stock market becomes more unattractive than the bond market, especially the credit contraction effect brought by high interest rates, although lagging behind, will not be absent. Especially, as the fiscal expansion of the United States turns to contraction, US stocks are facing the double negative effects of profit decline and liquidity contraction.

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