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Will Bigger Deficits and Higher Yields Crush Stocks?

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Be careful what you wish for and check your reaction if you get it.

That could be a fitting mantra for the U.S. stock market over the past week, when prices swung wildly, ultimately plunging major indexes into the 10% correction that many had been waiting for but fearing at the same time. By Friday, major stock indexes had recovered slightly, but few think the volatility is over.

What many in the stock market had been wishing for was a big cut in U.S. corporate tax rates, which would help boost earnings and sustain a market rally that was already more than eight years old. Corporate tax rates were cut permanently along with temporary cuts in personal income taxes in the recent tax overhaul that is expected to add $1.5 trillion to the federal budget deficit over 10 years.

Then Congress last week passed a two-year spending bill, halting a five-and-a-half hour government shutdown and fulfilling the market’s wish. But the spending bill is expected to add several hundred million dollars to the deficit this year and next, pushing it over $1 trillion by 2019, according to the Committee for a Responsible Federal Budget. (The fiscal 2017 budget deficit was $666 billion).

(Related: What Higher Yields Mean for Stock and Bond Portfolios)

Both moves are seen as feeding fears of rising inflation and putting upward pressure on interest rates, which were already heading higher on the expectation of more Federal Reserve rate hikes and the gradual reduction of the Fed’s $4.4 trillion balance sheet, aka quantitative tightening.

Even White House Budget Director Mick Mulvaney said Sunday in a TV interview that the U.S. could see a “spike” in interest rates this year as a result of a rising deficit. He added that the recent tax cuts could boost growth in the long term and reduce deficits, but few economists on Wall Street or in academia share that forecast.

(Related: Stocks Plunge, Market Enters Correction)

Inflation fears were already growing after the Labor Department reported a 2.9% annualized increase in average hourly earnings in the January jobs report, which set off the stock market rout that began on Friday, February 6.

“I think the real worry is the time at which fiscal stimulus is occurring,” says Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management. “Tax reform is occurring later in the cycle when economic slack is already declining, a condition that historically has led to rising inflation pressures.”

In addition, says Schutte, “The investing world is finally waking up to the reality that the artificial demand from central banks for long-term bonds is set to stop in 2018 as the economy expands, right as we have increased supply of government bonds from fiscal stimulus (think trillion-dollar deficits. This means we need real buyers to replace yield-insensitive central bank buyers and we believe those real buyers will likely demand higher real yields for the uncertainty they take buying long-term securities.”

Higher yields have been a primary catalyst for the stock market plunge. “Seemingly every time 10-year Treasury yields approached a four-year high last week, equities investors panicked, fearing the specter of higher inflation and a more aggressive pace of Federal Reserve rate hikes,” wrote Brian Chiappatta on Bloomberg, referring to the 2.88% 10-year yield (the 10-year closed at 2.85% on Friday and hit 2.9% on Monday morning).

Nick Colas, co-founder of DataTrek Research, wrote in his Friday market update that “the most notable thing about the Treasury/equity relationship over the last week is that they’ve both printed losses.” He doesn’t expect stock prices will hit bottom until long-term Treasuries “rally hard.”

Here are some other indicators that stock strategists are watching for signs of direction in both stock and bond markets:

  1. The federal government’s monthly budget statement, out Monday.

  2. The latest Consumer Price Index report, out Wednesday.

  3. Whether the S&P 500 tests and breaks through its 200-day moving average at 2,540, which could turn institutional investors bearish if the break is confirmed on a weekly or monthly basis, says Chris Hausman, director of risk management and chief technical strategist at Swan Global Investments.

  4. SVXY, the ProShares Short VIX Short-Term Futures ETF, which is essentially a bet on a stable or declining VIX — the volatility index. “It may not not survive the next round if the VIX keeps rising,” says Hausman.

SVXY has lost more than 91% since Feb. 1, about the same amount that XIV, VelocityShares Daily Inverse VIX Short-Term ETN, lost before the market open on Feb. 6, when Credit Suisse announced its upcoming liquidation on Feb. 20.

On Friday the Financial Times reported that Fidelity has halted retail purchases of SVXY, XIV and ZIV, VelocityShares Daily Inverse VIX Medium Term, but will allow sales of the funds and that TD Ameritrade is now requiring 100% margin on purchases of SVXY. Given these developments, investors should also be watching the VIX.

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