When political operator James Carville said nearly 30 years ago that he’d like to be reincarnated as the bond market because then he “can intimidate everybody,” he couldn’t have known this included the stock investors of 2023. He spoke as a top aide to President Bill Clinton during a previous bond-market crash that was serving to retrain an economy that was just starting to cruise while crimping the administration’s plans for expansive fiscal programs. Stocks had a choppy, enervating year in ’94 before the Federal Reserve pivoted having forestalled an inflation outburst, easing incrementally into a slowing economy in 1995 to help clear the way for the late-’90s boom. Something of a different set-up today, with inflation down but not decisively and the speedy surge in yields the perfect excuse to crystallize investor fears over everything including the durability of the economic expansion, equity valuations, the size of federal deficits, the health of banks and whatever else gets the butterflies fluttering in the gut. While there’s no precise or reliable way that stocks and bonds interact at all times, it’s surely the case that the U.S. stock indexes peaked just as the 10-year Treasury yield began its breakneck surge from 3.7% in late July to a touch of 5% this past Friday. At Friday’s close of 4224 on Friday, the S & P 500 is off 8% from the July high, with its equal-weighted version down 11%. Cyclical stocks have given back much of their accrued outperformance off the October 2022 low and credit spreads have finally started showing a bit of concern – all this despite (or is it because of) persistent upside surprises in the economic data and a budding recovery in corporate-earnings growth. .SPX YTD mountain S & P 500 YTD Yet the S & P was also at about the current level on Sept. 22, when the 10-year was a half-percentage-point lower, as well as on June 2, when it was at 3.7%. So, there is no trustworthy formula for calibrating cross-asset equilibrium. A year ago, the 3% threshold was considered one the stock market could not easily abide. It’s taken as a given in most corners of the investment business that higher rates available on bonds serve mechanically to compress equity valuations. Bank of America equity and quantitative strategist Savita Subramanian says this assumption is “mostly false.” She says that while higher real (inflation-adjusted) yields have broadly served to detract from stock multiples, “the swing factor is earnings and the correlation between rates and [price/earnings ratio] has been minimal historically because higher rates often meant better growth and higher – not lower – P/E.” What’s driving the bond market? It’s been the pace, causes and implied message of the yield surge that has undercut demand for equities in recent months. Extremes in bond volatility are not easily ignored across markets, given that Treasuries are the water in the pipes of the world financial system. The CME Group noted Friday that the 30-year Treasury volatility index just hit its highest level in a decade outside the worst of the Covid market shock. As Federal Reserve Chair Jay Powell himself detailed in a talk on Thursday, there are several factors driving the bond move in unknowable combination and with uncertain implications. The market pricing out imminent-recession risk and a rapid, belated appreciation of the Fed’s “higher-for-longer” message on rates are driving some significant component of the Treasury selloff, by most appearances. The move has occurred without much repricing of the Fed’s peak short-term rate or much of a rise in implied inflation expectations. The psychology around heavy supply of government securities, particularly longer-term maturities, since a July Treasury financing announcement, is also at play. Even though, as Bespoke Investment Group details, there is little historical correspondence between deficits and the level of rates (the short-lived late-’90s Federal surplus occurred alongside 4%-to-6% 10-year yields). Of course, even if long-term yields were rising largely in response to a better-than-expected economy and a patient but resolute Fed, the effect is to have long rates rising much faster than short-term yields, un-inverting the Treasury curve – which is something that historically happened as the economy neared a recession. It’s a tricky interplay of causes, effects and superstitions: A strong economy driving yields higher to test the economy’s resilience, taking mortgage rates to 8% and repricing credit as consumer-savings ebb, feeding a late-cycle narrative a full year after economists surveyed by Bloomberg News reached a 100% probability of a recession within a year. We are now in just about the longest stretch since a peak in the Leading Economic Indicators with the economy not (presumably) in recession, and the gap between LEI and current GDP growth is quite wide. Friday, yields did settle back a bit after another torrid ramp over the prior four days, a welcome moment of relief but perhaps experienced as the horror-film monster seeming to go away with a half-hour of running time left. Bond buying opportunity? At some level, the counterweight to higher yields is higher yields, as investors start to view the current income attractive to lock in now that real rates are near 2.5% on a ten-year look-ahead, better compensation than was available for most of the past two decades. We don’t quite know that level where buyers start to exert more sway, but if nothing else there is now more of a yield buffer available in fixed income against further volatility across a portfolio. As Bespoke laid out last week: “Since 1997, the current level of real yields (eighth decile) generally leads to the highest forwards returns for USD-denominated emerging-markets debt; high yield also tends to outperform. Periods of 6-month real yield change like the one we’re currently in (10y TIPS yields up 100+ bps) represent a 10th decile reading…that leads to above-typical returns across corporates, EM, and stocks. All signs point to the current backdrop being a good place to add risk in fixed income.” Gone unmentioned so far is the plague of atrocities and externalities that are dominating the front pages, spreading public unease and averting investors from risk. For a second straight Friday, the CBOE Volatility Index closed at a weekly high on heavy hedging demand. Gold is up 9% in the two weeks since the attacks on Israel. Typically and eventually, nonspecific worry over global instability or military conflict are buyable by opportunistic investors, though granted this bout comes with one house of Congress crippled by a small minority of the majority party and a prolonged auto strike. The instinct to stack it all on the “too hard to figure out” pile is understandable, no matter how good Netflix’s subscriber growth was last quarter. Which is how the stock market finds itself here, with real or incipient breakdowns in regional banks and transportation stocks, the median S & P 500 component down for the year. Four weeks ago here , as the air was full of predictions of a fourth-quarter rally, I mused: “It’s hard not wonder if the ‘typical seasonal weakness’ idea is so well-known and has played so close to the script this year that investors are leaning unduly on it…When sometimes, for a proper correction to run its course, a bit of fear and price-insensitive liquidation are desirable.” The S & P 500 has gone on to drop a bit further, rally weakly and then roll back toward a five-month low. We haven’t quite seen indiscriminate selling, though hedge funds as a group are now pressing short index bets hard. Broader sentiment is worried but not panicky.. Yet the index enters next week sitting right on potential support at its 200-day moving average; the Fed is done talking for its pre-meeting blackout period and might well be done tightening indefinitely; earnings are coming in well above forecasts even if the market is scoffing at them; the most profitable companies in history in mega-cap tech report results in coming days; the S & P has been up 15 Mondays in a row and, it must be said, the heart of the traditional fourth-quarter seasonal tailwind period is just underway just as many have begun to doubt we’ll enjoy any this year.
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