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After the S&P 500 index dramatically wiped out almost all its post-election gains, rattled by a bond market spooked by soaring inflation and climbing interest rates, the downturn was further fueled by President-elect Donald Trump's aggressive economic agenda. Investors cautiously dipped back into the market in this volatile environment, sensing an opportunity. This sparked a spirited rebound in the Dow and S&P, driven by the sturdy fundamentals of the US economy. Amidst the turmoil, investors began cautiously moving away from tech stocks while clinging to the remnants of a feel-good market vibe.

Indeed, Nasdaq struggled, weighed down by the outgoing administration's new U.S. export restrictions on artificial intelligence chips. These restrictions were designed to curb China's tech ambitions and keep cutting-edge technologies within the U.S. and allied borders.

Overnight, the dollar surged to a fresh 26-month high, tightening financial conditions both domestically and internationally, though it has since slightly retreated, potentially offering some respite for Asian markets today. The dollar's strong start to the week continues its impressive streak, rising 14 out of the last 15 weeks and appreciating 10% against major G10 currencies. This relentless climb is exerting significant pressure on emerging and Asian economies, which are feeling the pinch from both the robust dollar and rising Treasury yields.

Meanwhile, on Monday, China threw another curveball, announcing a staggering nearly $1 trillion trade surplus last year. Its exports dominated the global market, while domestic demand for imports remained tepid. When adjusted for inflation, China’s trade goliath last year outstripped any global surplus seen in the past century, overshadowing even the historical export powerhouses like Germany, Japan, or the United States post-World War II. Chinese factories are now spearheading a manufacturing dominance on a scale unmatched since America's meteoric rise post-war. This colossal trade performance will ignite further fury among U.S. trade hawks just as the new administration prepares to step into power.

Particularly notable is that Chinese export prices have significantly decreased in 2024. Therefore, the "real" surplus, when adjusted for these lower prices, is even more significant than the nearly $1 trillion reported. This amplifies the scale of China's trade surplus, underlining its extensive impact on global trade dynamics.

( Chart via Brad Setser)

No matter how you slice it, the surplus is enormous—more than double when Trump initiated the trade war, and COVID-19 brought the global economy to a standstill in 2020. It's hard to find anyone who could have predicted that these tumultuous events would lead to an even more enormous total surplus!

WHAT’S RATTLING MARKETS

What’s rattling the markets, even more, is that the recent surge in yields seems driven not by optimism over economic growth but rather by a ballooning term premium—the extra risk compensation investors demand to lock up their money in long-term bonds. This global ripple effect is hitting weaker economies particularly hard amidst brewing trade tensions and the looming spectre of the Trump administration’s inauguration.

Two significant forces traditionally steer Treasury prices: the pulse of Federal Reserve policy and the ever-looming spectre of inflation risk. These elements have remained relatively static since the Fed's initial rate cut. However, shifts in a less straightforward but critical metric—”term premium”—stir the waters.

This gauge assesses duration risk, which encapsulates the hazards of holding longer-term Treasuries—think the difference in risk between a 10-year and a one-year or five-year Treasury. Following a dynamic jobs report last Friday, the term premium, as tracked by the New York Fed, catapulted to heights unseen in over a decade, spotlighting the significant duration risk that diverges distinctly from inflation worries.

( Click on the chart to access the New York Fed interactive graph)

Duration risk and "bear steepening" in the bond market, where long-term bond yields increase more than short-term yields, don't always present as expected. There have been numerous instances when the U.S. bond market’s term premium was negative. This indicates that the additional yield investors required to hold longer-term bonds over shorter-term ones was less than zero, suggesting investors were less concerned about the risks of holding longer-dated bonds.

Despite the varying methods used to measure term premium and the debate among experts about its accuracy, data from Barclays shows that changes in the term premium have significantly driven most of the bond sell-off since the Federal Reserve's rate cut in September. This shift in premia reflects a changing investor appetite for risk and duration, which are central to understanding movements in bond prices.

Friday's economic revelations are a thrilling decoder for the current financial climate.

Amid the roaring furnace of the U.S. economy, rising bond yields loom large, driven by potential shocks on the horizon. Whether it's a Federal Reserve tightening—something the robust economy might well absorb—or an unforeseen spike in inflation not yet caught by the market's radar in TIPS or linkers, the financial landscape is bristling with uncertainty.

While some argue the recent surge in term premium may be overblown, it’s crucial to recognize that part of the yield climb reflects anticipations of an inflationary fiscal agenda alongside a Fed hesitant to implement yield-dampening policies. The sharp rise in long-end-term premiums from its nadir starkly contrasts with fundamental factors such as rate ambiguity and inflation threats. Yet, the fiscal horizon remains ambiguous as we await the final contours of legislative negotiations concerning spending cuts and the reconciliation bill's scale.

Moreover, while there's a growing apprehension among some Fed members regarding the upward trajectory of long-term rates and the consequent financial stricture, the continuity of solid economic data might forestall any dovish pivot in the near term. This delicate balance keeps the debate intensely alive—how will these competing forces reconcile in the dance of dollars and policy?

So, why the sharp nosedive in stock markets last Friday? Look no further than the stretched valuations that have ballooned over years of tech triumphs. The S&P 500, once priced at the pinnacle of optimism, sports a one-year forward earnings yield that has nudged down to 4.6%—identical to that of a 5-year Treasury note. This parity has flipped the script, making bonds a tantalizing alternative for investors with an eye on medium-term horizons.

But the plot thickens. While we might brace for further yield hikes, these could backfire by stifling global growth.

If this financial drama unfolds with economic growth and corporate earnings taking a hit, central banks could be forced to switch gears into stimulus mode. In this scenario, bonds could emerge as the unlikely heroes.

* Extrapolation bias is a recency bias that leads people to emphasize recent events when making decisions or predictions. This is particularly prevalent in financial forecasting. For instance, analysts might issue bearish predictions when stocks are at recent lows and bullish forecasts when they are near recent highs. The same pattern occurs with bond yields, with predictions often following recent trends rather than a balanced assessment of future probabilities.

This bias skews expectations and decision-making processes, especially among less experienced traders, where the ratio of weaker to highly profitable traders is roughly 9:1. Where the former tendency to over-focus on the near past rather than on a more comprehensive predictive analysis can lead to missed opportunities and misjudgments in rapidly changing markets.

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