Is the Global Monetary Tune Changing?

Markets have a history of confusing investors. ‘Black Swans’ regularly emerged from nowhere to twist current price trends into unknown and uncharted territories.

Who would have thought, at the start of this year, that President Trump would launch a surprise attack on Iran? Not any major investment bank or institutions.

The result of that belligerency has wrecked havoc in energy and fuel markets. With it, a host of newly-created headaches for central banks, indebted governments and household. 

As oil price - both WTI and Brent - now trades north of US$100 a barrel, the runway for a smooth landing is narrowing.

The Fed, the Bank of England, the ECB and the BoJ are now all mixing a hawkish tilt to their monetary policies in the coming months.

The ECB, for example, has recently raised its policy rate to 2.5 percent; while the BoJ is expected to hike its policy rate for a second time this year.  

In the US, the economic pressure to increase the policy rate - despite the wishes of the White House - is no less. The new Fed chief Walsh may want to stamp his mark as an inflation fighter, in the shadow of Paul Volcker. 

Based on these emerging trends, are we staring at a key inflection point in the monetary landscape? And, what will these higher borrowing rates do to speculative markets? 

How will higher rates impact markets?

There are at least three pertinent effects.

First, speculative pressure is ‘less hot’ these days, and may subside further if higher interest rates materialise. 

During a strong bull market, leverage is plentiful - and relatively cheap. Risk is (probably) underpriced. When borrowing costs increase, the cost of credit inevitably swell. Leveraged speculators face higher cost of interest. 

Last available data on US margin debt, for example, totalled $1.5 trillion. A 100bps rise on this gargantuan borrowing is no small change, even for large investment funds. Some over-extended positions may have to be cut to reduce borrowings. This adds to the supply side of the market, on top of those mammoths IPOs.

Already, I am noting some weakness in the small cap sector. 

The recent ‘failed break’ in US small caps, proxied by Russell 2000 ETF (ticker: IWM), suggests growing downside risk (Chart 1). Funds are probably exiting the ‘riskiest’ segment of the equity sector first. 

Second, the twin economic effects of higher inflation and borrowing costs will sap spending power eventually. 

A typical household, for instance, will have to spend more on daily essentials and mortgages. To maintain household liquidity, they probably have to cut back on discretionary spending. 

It is no coincident that McDonalds’s (MCD), Starbucks (SBUX), Walmart (WMT) et cetera all saw their share prices deflate substantially this year - even though S&P kept hitting new all-time highs (Chart 2). 

Even ultra-luxury stocks like Richemont (SIX:CFR), LVMH (FP:MC) or Hermes (RMS) are encountering market turbulence. The latter two hit 52-week lows this month. Expectations of a spending boom are dwindling.

Rocketing diesel prices is also weighing on a few transportation stocks such as Old Dominion Freight (ODFL). The cost of delivery will undoubtedly rise as long as diesel prices stay elevated.

Thus, the ‘feel good’ factor that normally accompanies a euphoric bull is slowly sapped away by growing uncertainties. Will fuel prices surge further? Will companies retrench and cut investments?

This brings us to the third effect: AI spending. 

It is indisputable that AI infrastructure buildout will cost trillions. Data centres, computing chips, AI models upgrades et cetera are really expensive kits. 

With borrowing costs marching upwards relentlessly, these investments will become even more expensive.  

In the past twelve months, aggregate AI-related debt issuance is estimated at a staggering $550 billion. Animal spirits and ample liquidity are two important factors in absorbing this tsunami of AI debt.  

But good times like this seldom last. As Treasury yields rise, it is kicking these AI debt prices down. (Bond prices move inversely to yield.)

Take Alphabet’s 2060 bond (ISIN:US02079KAG22). This debt security hit 6 percent yield recently as investors re-price the cost of holding this bond (Chart 3).  

For Oracle’s 2056 bond (ISIN:US68389XEB73), yield of that debt soared in 3Q to 7.8%. 

If global central banks start hiking rate in unison, soon we will be talking double-digit AI interest rates. 

Can the booming AI sector withstand this credit onslaught? I’m not so sure. The risk calculus has changed markedly, in favour of credit providers. 

Hence, for the sake of ‘safety’, the CEO of Anthropic has recently called for ‘frontier AI pacing’. That is, the industry should decelerate the progress of AI buildout. 

If this happens, will AI securities tank? Again, the risk is potentially high. Revenue booking, earnings outlook and investor sentiment could all be downgraded if AI spending starts to slow. 

Remember a lot of AI spending is ‘circular’. This virtuous cycle can easily turn into a vicious one. I re-paste this picture (from Saviour Wealth) to remind readers of this risk (Chart 4).

Conclusion

Unpredictability is a built-in feature of financial markets. As S&P cruises near its record highs, the foundation on which the rally is built on is slowly changing. 

Higher inflation, higher rates outlook, and potentially, higher earnings disappointment. All these may reduce speculative fever.  

During this phase, price volatility will likely increase as large investors de-risk and re-position their portfolios. For normal investors, perhaps holding some firepower in reserve may be a good idea if price volatility brings about good long-term bargains.