A market in suspense

Good day. The People’s Bank of China intensified its defense of the renminbi yesterday, after the Chinese currency fell to its lowest level since 2023. The People’s Bank of China said it would sell 60 billion yuan ($8.2 billion) in banknotes in Hong Kong in January, its biggest sale since Auctions began there in 2018. Chinese authorities have committed to keeping the currency stable. But with China’s struggles and America’s strong economy, that may require serious firepower. What is China willing to do? Send us an email: robert.armstrong@ft.com and Aiden.reiter@ft.com.

Maximum uncertainty

Something significant has changed in the markets over the last month. We can all feel it. What exactly is it?

The change is noticeable in all corners of the market. But let’s start with actions. In the months before the election, U.S. stocks rose in fits and starts. Immediately after the election, they received a big boost, with small-cap (i.e. riskier) stocks taking the lion’s share:

The fun didn’t last. Towards the end of November, small caps began to decline and large caps began to trade sideways rather than up. Rates clearly have something to do with this. Here are the small caps compared to the 10-year Treasury yield:

After the boost from the election results, the smalls got a second boost from falling yields about a month later. When they rose again in late December, the entire stock rally reversed.

That’s a pretty simple story: Higher rates are bad for stocks. But, of course, higher rates are not always bad for stocks. So what kind of rate hike is this? And why don’t stocks like it?

One explanation that won’t work: the idea that inflation is bad for stocks, and investors have become convinced that the Federal Reserve is willing to let inflation get out of control. Nominal Treasury bond yields can be decomposed into real rates (for which yields on inflation-protected Treasury bonds are an indicator) and inflation expectations, or “equilibria” (the nominal yield minus the protected yield against inflation). And it is real yields, not breakeven points, that have done most of the work in driving nominal yields higher:

That said, the market has come to believe that the Federal Reserve will have to lean a little more toward inflation. The expected reduction in the official interest rate has been increasingly smaller:

The expectation that rates will stay high longer partly explains the rise in yields, but not entirely. This is visible in the fact that the long end of the curve has risen more than the short end, sensitive to rate policy. The gap between the two-year yield and the ten-year yield has increased rapidly since late November:

This steepening of the yield curve is largely explained by a rising term premium. The term premium is the additional yield that long-term bond investors demand on top of the expected path of short-term rates. It’s additional compensation for staying long-term; in other words, a margin of safety.

Why the term premium moves is always a topic of debate. But in the current case, I think the rising premium is clearly attributable to Treasury investors not knowing what the heck to expect from the economy, monetary policy, or the market. Let’s consider another change that occurred in late November in the stock market. Along with all the changes in the bond market at that time, we saw small caps start to underperform large caps, the equal weight S&P 500 started to underperform the cap weighted index and investors fled value stocks in favor of growth:

Why do these changes indicate an increase in uncertainty? Because they are all driven by a move towards stocks that have performed in recent years, or stocks that are currently perceived as the safest bet: US large-cap growth, primarily Big Tech oligopolies. Going into big growth is the new form of conservative investing.

The big shift in the stock market, then, is not driven by a particular narrative about the economy, the trajectory of earnings, or the direction of capital flows. It is driven by the lack of a clear narrative. It is debatable whether this is entirely due to the political transition taking place in the United States. However, it seems that the incoming president’s policy of strategic ambiguity is difficult for the market to process.

Every moment feels uncertain as you live it. There is reason to believe that this moment is actually more disconcerting than most.

A question for readers about stablecoins

Over the holidays, stablecoin issuer Tether made headlines when large cryptocurrency trading platform Coinbase announced that, for regulatory reasons, restrict EU traders buy Tether coins. The market capitalization (number of coins in circulation multiplied by their value) of Tether’s USDT, the world’s largest stablecoin by a mile, fell a bit, and other stablecoins perked up at the news:

All of this left us with one question, which we put to you: what is the current use case for stablecoins in the market? Specifically, will stablecoins like Tether have an important role to play in cryptocurrency trading as cryptocurrencies become more common, more liquid, and better integrated with fiat finance? Why use stablecoins to buy other cryptocurrencies? We do not use brokers to trade stocks, bonds, currencies, gold, grains or real estate. Why should cryptocurrencies be different?

(We are skeptical about cryptocurrencies for economic and philosophical reasons, but we are not experts on the mechanics. If we miss any technical points in what follows, please email us.)

Stablecoins are cryptoassets pegged to fiat currencies. The initial idea was to facilitate transactions between fiat currencies and volatile cryptocurrencies by holding a stable digital token representative of a dollar on an exchange. As Tim Massad, former head of the Futures and Commodities Trading Commission, told us, they are “on-chain cash.”

For Tether and its competitors, this is big business. According to Tether, each coin it issues is backed one-to-one with fiat reserves, typically deposited in short-term U.S. Treasury bonds, like a money market fund. But money market funds are paying 4 to 5 percent right now; when a user buys a Tether coin, they do not get that return; Tether yes. Essentially, stablecoin issuers are earning returns on users’ fiat money (plus transaction fees!) in exchange for holding the cash and issuing the token. There is a lot of economic friction here.

Tether and other stablecoins have another purpose, of course. As accessible dollar-pegged assets, they “liberalize” access to the dollar and facilitate global transfers. They are becoming an unbanked, unregulated, dollar-based payments system. That’s fine with us, although we think currencies will find it difficult to compete with fiat currencies and other cash transmission tools, except among people who want avoid regulation and detection.

But on the cryptocurrency trading side, we are stumped. Cryptocurrency supporters are desperate for regulators to back the asset class and integrate it into the traditional financial system. If cryptocurrencies become easier to hold, whether through a 401(k) or a regular brokerage account, why continue using stablecoins? Wouldn’t it be just as easy to use dollars to buy cryptocurrencies? Is there any friction between fiat currencies and cryptocurrencies that stablecoins could still solve? Let us know.

(Reiter)

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