Testing Hypotheses

One of the criticisms often levied against the social sciences is that they cannot conduct experiments like the natural sciences. Yet, experimentation is not possible in all of the hard sciences, like parts of physics or astronomy. Even if experimentation is difficult in the social sciences, hypotheses can still be tested.

This is definitely the case in the markets. Some observers opined that the sharp rise in interest rates would have a strong impact on investment strategies. It would mark the deathknell of carry-trades. The market would price risk more in line with what the academic models and officials seem to think is more appropriate. The bull market is stocks would end and the love affair with emerging markets would sour.

The price action in the capital markets provides little evidence to support these hypotheses. In fact the resilience of investment themes in the face of the increase in interest rates is most impressive.

The sell-off in US bonds begin in earnest a month ago. Over the past month the US 10-year yield has risen 49 bp whle the 2-year yield has risen 33 bp. Over the past week, the 10-year yield has increased by 9 bp and the 2 yr 8. The short-end has also back up with the implied yield on the Dec Eurodollar futures having risen 20 bp over the past month and 4.5 bp over the past week.

The yen remains weak and yen carry-trades still seem to be in play. While Japanese rates have been dragged higher, not as much as in the US and Europe. The widening interest rate differentials continue to encourage carry-trade strategies. The yen has weakened 2.7% against the dollar over the past month and half of that has taken place over the past five sessions. It has lost 1% against euro in the past week, and was essentially flat over the prior three weeks.

The strongest currencies continue to be high yielding currencies. Over the past week, the Brazlian real has appreciated by 2.1% against the dollar and 3.25% over the past month. Unprecedented intervention at the start of this past week has weighed on the New Zealand dollar, where the cash rate was unexpectedlyhiked to a record 8% earlier this month, but it is still up more than 2% over the past month, making it among the strongest performers against the greenback.

Emerging equity markets have not been hampered by the rise in interest rates. The MSCI Emerging market index has risen to new record levels. It is up a little more than 4% over the past month, with a little less than half being recorded over the past week.

The bull run in the major equity markets has also not been derailed by the backing up of interest rates. Over the past month the S&P 500 has rtisen about 2.25%, with the bulk having been recorded over the past week (~!.8%). The high flying German DAX has risen 6.6% over the past month, and again with the lion’s share have been seen over the past week (~5.4%). This was week’s gain of about 3.2% was enough to lift the UK’s FTSE into positive territory for the past month (~2.2%). Even the Japanese stock market, which often moves inversely to the Japanese government bond market, has moved higher despite the backing up of rates. The Nikkei is up 2.6% over the past month and a little more than 1% over the past week.

Nor does it appear the rise in rates has diminished the market’s appetite for are often thought to be higher rise assets. The JP Morgan EMBI+ spread over US Treasuries remains within spitting distance of its record lows. Consider thart Brazil’s benchmark global dollar bond (7 7/8 of 2015), one of the most liquid of the emergign market debt instruments, has seen the yield rise 48 bp over the past month comnared with 49 bp rise in the US 10-year Treasury.

It is too early to tell whether the merger and acquitision wave will be undermined by the higher interest rate environment. Although there is some annecdotal reports warning that this may indeed be the case, thereseems to be other dirvers of M&A activity, which is running well ahead of last year’s pace in both Europe and the United States (both have reportd deals thus far this year exceeding $1.2 trillion), than interest rates per se. For example, rising commodity prices may be enccouraging increased consoldiation in that space. Companies, like Berkshire Hathaway has signaled a desire to put some cash to work and is looking for a sizeable acquistion.

Surely it is naïve to just look at the cost of a deal (interest rates); the anticipated return also needs to be taken into account. Unlocking value through a private equity transaction or a spin-off may boost the anticipated return and offset the higher cost.

If the key force lifiting interest rates is a new appreciation for the growth trajectory of the world’s largest econmies, as we believe, that should also boost earnings. The critical coinsideration may be the spread between the cost capital and the earnings stream it can purchase. This still seems to offer favorable incentives that encourage M&A activity. Many of the observers warning about the end of the M&A wave have not even considered the Q-ratio, which measures the cost of building a real asset to buying it. Recent caluculations seem to suggest that buying a real asset may often still be cheaper than building it.

The important take away message from this cursory review is that at least during the past month in which the rise in interest rates has been most dramatic, the impact on the investment themes that prevailed previously still seem to be working. It is true that at the beginning of the interest rate adjustment that many investors paused to see the shake out.

However, Treasuries and the US dollar have not been able to make much new headway since mid-week, depsite the strong retial sales, business inventories, and robust Beige Book. This offers a prima facia case for thinking that the initial adjustment is over and that interest rates and the dollar may ease (especially against the European currencies) in the coming week.