March 7, 2023
Longer-dated bond yields have limited room to lift from current levels given hawkish rate expectations and the potential for a more benign February Jobs Report this Friday. Terminal rate expectations have risen 70bp since the January payroll data and a similarly strong February report is now required to drive incremental upside in bond yields. The ‘official’ consensus estimate for February payrolls is now +225,000, but whisper numbers are starting to push toward +300,000. From a technical perspective only, we note bearish momentum divergences in 10 and 30-year Treasury yields mid-last week and yields on both tenors reversed last Friday.
A positively sloped 5/10 yield curve is our market-based indicator for an imminent Fed pivot. The 5/10 curve inversion has now widened slightly beyond levels from last September at -30bp. This level of curve inversion matches peak rate hike expectations from every cycle except during the 1975-1981 period. We expect the 5/10 curve inversion to narrow in the days ahead, but further widening in the spread would increase expectations for a longer tightening cycle and add downside pressure on equity markets. A narrowing in the curve inversion to -20bp or lower would be a bullish near-term signal for equities.
Any further widening in the 5/10 curve would be particularly bearish for small cap stocks that make up the Russell 2000 (RTY) index. This is because small cap companies typically use greater amounts of floating rate debt and are therefore more sensitive to a rising cost of capital.