What could crash stocks? Here's the straight answer

US equities took an extremely rare beating on Wednesday after Boeing (BA) and AT&T (T) disappointed investors with below-estimate results. While the bulls managed to push prices back up off the day's worst levels, they couldn't erase the sense that a long-delayed (and healthy) correction could be near.

Additional headwinds included reports Republicans were considering limiting 401(k) contributions to minimize the revenue impact of planned tax cuts and nervousness about President Donald Trump's looming choice of a Federal Reserve chair.

But the real reason the market's utopian, unblemished uptrend got marred? Bond market volatility led by the threat of higher interest rates driven by inflation. Rising rates and inflation are bull market killers.

Expectations of higher inflation amid ongoing economic growth -- combined with the Fed's accelerating tightening of monetary policy -- are fuelng a nasty sell-off in Treasury bonds. In this environment, when all assets except volatility climb in unison, any asset price deflation cannot be tolerated.

Thus, the weakness is spilling over into equities.

Overall, so-called risk-parity funds (which depend on stocks and bonds moving in opposite directions) have suffered losses for the lasts six days. That's the longest downtrend since July. And if it continues, it could challenge the very basis of this historic bull market in stocks: Ultralow interest rates and a near 30-year bull market in bonds.

Rates are already on the move.


The 10-year U.S. Treasury yield returned to levels not seen since March this week. The two-year yield, after a tepid auction, has pushed to highs not seen since 2008 at 1.6 percent (chart above).That's a 10-fold increase from the low of 0.16 percent set in 2011.

This is a consequence of the Fed's policy tightening cycle, which started back in December 2015 and accelerated this month as policymakers began the process of rolling back the central bank's bloated $4 trillion-plus balance sheet. Also, investors have a creeping sense that inflation is about to jump higher, led by tight labor market conditions and steady GDP growth.

Bank of America Merrill Lynch economist Ethan S. Harris outlines a number of reasons to expect higher inflation, and thus higher interest rates, in a recent note to clients: 

  • Job openings as a share of the labor force are now at the highest level in the 17-year history of the data series, reflecting job market tightness.
  • The output gap -- the measure of the economy's actual output vs. its full potential -- continues to shrink, according to estimates from the Congressional Budget Office, the International Monetary Fund and the Organization for Economic Co-operation and Development.
  • Rental vacancy rates are near the lowest in more than 20 years.
  • Industrial sector capacity utilization is rising as supplier deliveries are at the slowest since 2004, pointing to rising demand on the supply chain.

But why would higher inflation and higher interest rates be a worry? Deutsche Bank strategist Jim Reid, in the bank's latest long-term asset return study, warned these conditions could trigger not just a typical recession but a new financial crisis, given the dangerous connection between higher government debt and more frequent financial shocks.

Much depends on President Trump's pick to lead the Fed and the course of monetary policy into 2018. The futures market has already baked in another rate hike in December, pushing short-term interest rates to a high of 1.5 percent. 

Odds of another hike by next June stand at 45 percent (which would send rates to 1.75 percent), while the odds of two hikes (and rates of 2 percent) are at 17 percent.

If inflation takes off, as Harris expects, these odds should increase.

Higher interest rates have a wet blanket effect on bull markets and economic expansions by choking off the flow of credit and weighing on financial asset prices generally. This time, it would be made worse by the fact Wall Street has become accustomed to a pattern of ever-decreasing bond yields and, therefore, ever-higher bond prices (given that the two move in opposite directions).

If yields keep rising, the accompanying bond price deflation will ripple through portfolios and send shockwaves through the financial markets as everything from corporate debt-fueled stock buybacks to debt-funded mergers and acquisitions are hit. 

And assuming this is led by inflation, the Fed will have no choice but to let it happen -- which is probably the single most terrifying prospect to stimulus-addicted investors. 

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.