Inside Markets — Bond Market Volatility

The end of a Fed hiking cycle once inflation is vanquished should be positive for risk assets. Equities have reacted favorably to the end of past hiking cycles with the SPX returning an average of +6.6% over 3 months and +8.7% over 6 months. Cyclical sectors and bond proxies generally outperform as bond yields move lower.  Fed messaging over the past two weeks has coalesced around the idea that further rate hikes are unnecessary.  Rising expectations for Powell to deliver a similar message this Thursday are partially responsible for today’s equity rally. Unfortunately, the rationale behind the recent message isn’t that inflation has been solved, but that rising bond yields are essentially doing the work for the Fed. We expect Powell’s message this Thursday will fall short of the mark and the all-clear on inflation will wait until Q1‘24 at the earliest.

Two weeks ago, we noted that the backup in bond yields had become disconnected from fundamental drivers like inflation expectations, growth data and Fed expectations.  Seemingly on schedule, bond yields moved lower last week on a flight to safety trade following the spike in geopolitical tensions and dovish Fed comments. Unfortunately, the non-fundamental drivers of the backup in yields remain in place as increased Treasury issuance and Fed QT operations apply upward pressure on longer-dated yields in particular.  Look for bearish curve steepening amid shallow market breadth to drive increased bond market volatility in the near-term.

The MOVE index that measures bond market volatility has already increased more than 30% since its 52-week low in September. Further resurgence in the MOVE index risks spilling over into the equity market like it did in 2018.  In addition to an unfavorable supply/demand dynamic, risk of a material change to the inflation narrative would be another potential driver of increased bond volatility.  A spike in oil prices from current levels would generate concerns of demand destruction and the emergence of a stagflation narrative that takes the MOVE and VIX higher.  The VIX currently sits at ~18 with levels north of ~22 becoming a headwind for rally attempts.