October 4, 2023
The S&P 500 (SPX) extended its recent pullback yesterday toward its 200-day moving average and bullish inflection at ~4200. The index reached oversold levels last week, which increases the likelihood of a near-term relief rally. However, we remain tactically bearish amid rising realized equity volatility and widening fixed income credit spreads.
The bearish distribution patterns that developed in cyclical proxies like the Russell 2000 (RTY), equal weight S&P 500 (SPW) and EuroStoxx 50 (SX5E) from late July have all broken key support levels. Markets are a leading indicator and the breakdown in cyclical proxies is an early warning that follows a 16-month long yield curve inversion. Historically, every curve inversion that lasts more than a month resulted in a recession-driven bear market 19-24 months forward.
The recent backup in yields has been largely disconnected from fundamentals as inflation breakeven yields remain little changed across all tenors. Some of the backup is related to an imprecise convergence between yields and terminal rate expectations that tend to occur at the end of a hiking cycle. Position hedging in futures markets has also been another factor, but various indicators suggest positioning is now approaching neutral levels. Increased Treasury issuance and rising US fiscal deficit concerns seem like unresolved drivers of higher yields, but these items could be addressed before the expiration of the short-term continuing budget resolution in November. The disconnect between bond yields and fundamental drivers has now reached historic extremes seen in 2013, 2015 and 2016. All three episodes ended quickly and we see current levels as a rational place to add duration.
Today’s reprieve in the yield backup follows weaker-than-expected ADP private payrolls and mostly inline services ISM that included a dip in employment and steep decline in new orders. The September ADP private payroll gain of 89,000 missed consensus for 140,000, while noting another decline in compensation growth. The ADP report isn’t a major input for most economists, but the relatively small decline in yields reinforces concerns that increased Treasury issuance and elevated US budget deficits are partially responsible for the rise in yields. Reports discuss the extent of the yield backup and how the velocity of the move could disrupt financial markets.