November 29, 2023
Yesterday’s dovish Fed comments, small uptick in consumer confidence and better-than-feared early holiday shopping trends has started early rotation into cyclical equity groups like banks, REITS, autos and housing. For now, the source of funds for this rotation looks like mega-cap Tech. This early rotation will only last as long as bond yields maintain their downward trajectory and could quickly unravel if/when 10-year nominal yields cross back above 4.48%. The recent rally in software stocks also suggests that investors may be positioning for eventually lower real yields. Ten-year real yields currently sit at +206bp with downside momentum likely to accelerate at levels below +200bp. Software multiples and real yields have a strong negative correlation. We’d expect some degree of multiple expansion when 10-year real yields cross below +160bp.
Unfortunately, the November equity rally has resulted in a reduced positioning tailwind, elevated bullish sentiment and compressed realized equity volatility. Low equity volatility is a bullish development that can also push equities to extreme overbought levels. The Goldilocks theme can continue into December as long as macro data supports it.
Key catalysts include: 1) ISM manufacturing on 12/1; 2) ISM services on 12/5; 3) November Jobs Report on 12/8; 4) November CPI on 12/12; 5) FOMC meeting on 12/13 and; 6) November retail sales on 12/14.
An imminent Fed rate cut should be preceded by a sufficiently positive 5/10 yield curve. The lead time is usually 1-2 months. In our opinion, the 5/10 curve needs to reach +19bp before signaling a rate cut. The 5/10 curve has improved but only slightly to +5bp at the moment. Without an imminent Fed rate cut, investors will be faced with a more challenging macro backdrop, rich valuations and elevated bullish sentiment. And it’s very difficult to tell the difference between a normal slowdown and the initial stages of recession.