Inside Markets — New Phase

We entered a new phase in markets when 2-year Treasury yields broke above 4.80%. This was the level we identified as significant in our March 14th edition of Inside Markets.  Equity markets ignored the steady uptick in yields until 2-year yields broke above 4.80% last Wednesday (4/10).  The 4.80% level is technically significant because it sits just above the 200-day moving average for the 2-year.  It’s also significant because the break below 4.80% back in late November corresponded with the repricing of Fed expectations to include 3 cuts (>75bp) in ’24.  Last Wednesday’s break above 4.80% resulted in another significant repricing of Fed expectations with just ~30bp of cuts currently priced for ’24.

The November-March phase of subdued realized equity volatility and multiple expansion resulted from benign macro conditions that included declining  inflation, resilient growth and >75bps of rate cuts beginning in Q2.  Economic growth remains resilient, but inflation is no longer declining and the Q2 Fed pivot has been postponed at best.

To be fair, the new phase is actually characterized by stronger economic growth and a rally in commodity prices. The new phase doesn’t have to result in a lasting top in equities, but macro conditions are no longer benign, which increases the likelihood of volatility spikes that generate downside pressure on forward multiples.  The ongoing curve inversion (becoming more inverted) implies the US economy is ‘late cycle,’ which generally leads to narrow equity leadership and more crowding in mega-cap growth stocks.  The Russell 2000 (RTY) test of range resistance in March failed with the hope of a catch up trade indefinitely postponed. Ongoing curve inversion only increases the risk that something in the economy eventually breaks and increases the significance of internal market signals.  For now, we maintain a  tactically bearish outlook on the SPX at levels below 5120 and see risk of accelerated downside at sustained closing levels below 4980. It’s also important to note that many stocks are now at/near short-term oversold levels, which increases the likelihood of a test at ~5255.