There was a lot of bearish sentiment ahead of the US open today after stocks plunged on Tuesday. So far on Wednesday, the markets are mixed and the sell-off hasn’t been as severe. So what next for risk assets?
Below we assess the reasons why we may see stocks fall further and why the sell-off may be shallow, we will then give our view as to where we see stocks going next.
Why bearish sentiment may continue:
US indices closed at fresh lows on Tuesday and there was little respite in the selling pressure during the day. This is a bearish sign, and suggests that the bears may not have had their fill of selling risky assets.
The lead indicators are also looking bearish. The Dow Jones Transportation Index, which tends to be a bell-weather for US stock markets, may have recouped some early losses on Wednesday, but it is still looking weak on the month. If we see a pick-up in risk sentiment, then we would expect to see the Transportation index recover first.
The other thing to watch is the performance of Tuesday’s biggest losers – the banks and industrial stocks. Banks, including Goldman Sachs and Bank of America, are starting to look weak after an initial pop higher at the open, while Caterpillar, one of the Dow Jones’ biggest decliners on Tuesday, has managed to pick up after a dip at the open on Wednesday. If we see these stocks come under further pressure on Wednesday then the sell-off may continue to gather momentum.
Reasons why the sell-off may be short-lived
Treasury yields have fallen sharply again on Tuesday, and are 25 basis points lower than they were before last week’s Fed meeting. Yields are now at their lowest level since the start of this month. The decline in US Treasury yields has led to a reduction in expectation for another rate hike in June, the probability of this has fallen from nearly 50% to 46% today. Lower yields and the prospect of a slower pace of rate hikes should be good news for stocks as it reduces the cost of capital.
The Vix index is also worth watching, since it has retreated on Wednesday, and only briefly jumped above 13 on Tuesday at the peak of the sell-off. Normally we see much larger spikes in volatility when stocks sell off sharply. Thus, this sell off could be more of a moderate affair, and losses may be capped.
On balance, even though there are growing reasons to sell stocks, Tuesday’s decline may not be the start of a market rout. Lower Treasury yields could cushion any fall in stocks, and until we see the Vix pick up then we doubt that the sell-off will last. There are two things that could trigger a deeper sell off on Thursday: Yellen talking and Trump’s first legislative test in Congress when he tries to repeal Obama’s healthcare act. If Trump fails to get his way on Capitol Hill then the Trump trade could falter once more, especially if Yellen rolls back on her less hawkish message from last week.