Is the writing on the wall for the FTSE 100?

<p>The pound has been the focus of investors’ concerns about a Hard Brexit; while the pound has experienced a ‘flash crash’ and plunged to its […]</p>

The pound has been the focus of investors’ concerns about a Hard Brexit; while the pound has experienced a ‘flash crash’ and plunged to its lowest level in more than 31 years versus the dollar, the FTSE 100 has quietly jumped above 7,000 and threatens to break to a fresh record high. But could the FTSE 100 be the next victim of the Hard Brexit rhetoric currently coming from Whitehall?

Bond markets sound warning signal for the FTSE 100

If we look at the bond markets for guidance then we believe there is reason to be cautious about the outlook for the FTSE 100. UK 10-year bond yields have risen above 1%, for the first time since June, rising more than 50 basis points since bottoming out in August. This is worth noting. Bond investors are considered to be ‘rational’ and informed investors with long-term views, thus when there is a shift in the direction of a bond market (bond yields move higher, bond prices lower as price and yield move inversely to each other), it can suggest a long-term shift in bond investors’ thinking.

What rising bond yields really mean

Figure 1 below shows the UK’s yield curve (white line) and the FTSE 100 (orange line). The yield curve shows 10-year yields minus 2-year yields. At the moment the spread between 10-year yields and 2-year yields is steepening, so 10-year yields are rising at a faster pace than 2-year yields. This suggests that the market expects interest rates to be higher in the future than they are now. It doesn’t take a rocket scientist to come to that conclusion since interest rates are currently at a record low, however, it is the pace of the increase in 10-year yields that may eventually cause jitters in the stock market.

Bond yield curves and their predictive powers

A steepening yield curve can be a sign that investors think inflation is set to rise. 5-year breakeven rates (a good way to gauge UK inflation expectations) have risen above 3% for their first time since 2013. Interestingly, the pace of increase has surged since the EU referendum vote in June. This suggests that rising inflation expectations have been directly driven by the sudden decline in the pound.

A steepening yield curve is usually a sign of healthy economic growth: the economy expands, the BOE needs to raise interest rates at some point to stop the economy from overheating. However, the difference this time is that we have a major economic uncertainty hanging over us – the outcome of the UK’s Brexit negotiations. These negotiations could take many years, and we have no idea what the UK’s post EU exit economy is going to look like. Due to this, a steepening yield curve is a cause for concern – rising inflation caused by a decline in the pound could trigger BOE interest rate increases just at the time that the UK economy may need the support of the central bank.

Why this matters for the FTSE 100

As you can see in the chart below, each time the FTSE 100 has peaked the yield curve has been flattening, in contrast, a steepening yield curve has coincided with future weakness in the FTSE 100, dating back to 2001. Thus, if history repeats itself (nb, it doesn’t always do that), the top-performing FTSE 100 could be on borrowed time if we continue to see a steepening yield curve.

The lesson:

If you are a stock market trader look at the bond market for direction. It is currently giving us a warning sign that the FTSE 100 may not be able to sustain its current gains and could be ripe for a sell off. While a steepening yield curve does not have a perfect correlation with the FTSE 100, which makes it difficult to predict the timing of a potential sell off in UK stocks, it does suggest that UK equity investors should be cautious before adding to long positions at these high levels.

Figure 1:

10_10_01

Source: City Index and Bloomberg

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