- Parts of US financial markets, already rich by historical standards, are facing “melt up” risks.
- This is driven by a mix of exuberance, liquidity, and a plethora of products to play the markets.
- Crypto and leveraged tech ETFs are the flavours of the moment.
- Meanwhile, the fixed income market is worried about inflation and fiscal risks.
- Short-term market frenzy could set the ground for a disruptive sell-off.
Commentary: “Melt-up” risks
The following asset price movements since the 5th of November characterise the post-US election market reactions:
The fact that companies and asset classes that will likely benefit from Donald Trump’s policy measures have rallied and vice versa is unsurprising. The 40%+ rally of the likes of Bitcoin and Tesla however should warrant caution. We think that between deregulation and tax cut expectations, parts of US financial markets, already rich by historical standards, are facing “melt up” risks. This could complicate macro policies next year, setting the ground for a major market correction.
How does “melt up” transpire? It is a heady mix of exuberance, liquidity, and a plethora of products to play the markets. Crypto assets have been trading in the exchange traded fund markets this year, offering intraday liquidity and easy entry/exit. We are also monitoring the proliferation of highly leveraged exchange traded funds that track the stock of tech companies, the amount of daily trading in which is approaching USD100bn. These trades are not restricted to small-time day traders; large institutional investors and high net worth individuals are deeply engaged as well. There is a degree of the old “as long as the music is playing, you've got to get up and dance” phenomenon in the making; no one wants to be left behind in a rally of historic proportions.
Is there a build-up of systemic risks? Regulators don’t seem to think so, taking solace from tight labour markets, strong wage growth, and sound corporate/household balance sheets. But such complacency should be seen in the context of the several financial market crashes in this century being missed by the early warning models of financial market stress.
What could be the trigger? It has to be the Fed and interest rates, in our view. The melt-up dynamic, if it spills into January, would raise serious questions about the inflation outlook and financial stability. Even if policy makers don’t flag the latter publicly, a number of market participants will begin to hedge against that possibility. Already, the treasury curve have rotated up considerably this month, showing rising discomfort about the inflation and fiscal outlook. Combine this with the relentless rise in asset prices, and the likely policy volatility that may ensue after January 20, we are inclined to see the current good times with some trepidation.
A key follow-up question is what would all this mean for emerging market economies. Our key concern right now is the FX space, where the current USD rally becomes a disruptive one in the lead-up to late January as tariffs are announced. We don’t think key EM central banks would try to fight the USD by intervening heavily, which would mean room for further depreciation of EMFX. Once the inevitable US market correction comes, there will be room for regional stocks and currencies to rally, but expect plenty of vols before that.
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