Inside Markets — Election Expectations

Ten-year bond yields have risen +65bp since mid-November on a combination of firmer macro data and election expectations for a Republican sweep.  A fair value bond valuation model attributes ~45bp to macro data, which leaves ~20bp to election expectations. Higher yields in a Republican sweep scenario are based on the increased likelihood for the extension of current tax rates (set to expire at end of ’25) and the potential for lower corporate tax rates that the CBO scores on a revenue neutral basis. Bond yields are lower today as participants mull Friday’s weak Jobs Report and hedge election related uncertainty.  In our opinion, the October Jobs Report was objectively weak and the risk of higher yields in a Republican sweep scenario have been overstated.  Last week, we discussed how deeply oversold the bond market had become based on the Treasury put/call ratio z-score reaching extremes from last October when 10-year yields were testing 5%. We also noted reversal indicators in 5, 10 and 30-year tenors on Thursday 10/24 and again on Tuesday 10/29.  Thirty-year yields are off Friday’s high of 4.58% to 4.51% this morning with some initial short covering taking long yields to 4.43%.  We’d expect a more significant pullback in yields on a break below 4.38%.  While this seems subtle or insignificant, a move below 4.38% would likely trigger notable outperformance in beta/rate sensitive equity groups like homebuilders, regional banks and tower stocks.

The macro backdrop will be the primary driver of markets with the potential for election results to serve as a near-term clearing event for equities.  In our opinion, election uncertainty has resulted in more risk-off/neutral positioning rather than positioning for alpha generation. Consider than fund flows since 2019 (September data) have gone to Cash up +$3.47T, Bonds up +$2.03T and Equities +$55B. We also see the potential for election results to be a clearing event for incremental US economic activity given that a non-trivial percentage of September/October ISM manufacturing respondents cited election uncertainty as a reason to defer capex decisions.

Rising/elevated volatility is the primary near-term risk for equity markets.  The CBOE Volatility Index (VIX) reached uncomfortably elevated levels just above 23 last Thursday. The VIX has pulled back to a still elevated level of ~22 today.  Higher volatility results in multiple compression and the current ~21 forward multiple on the SPX increases the risk of a VIX spike.