September 28, 2023
The move in yields has been linked to the Fed’s higher-for-longer message, an extension of the rally in crude prices and increased Treasury supply. Eurozone bond yields rise this morning despite cooler-than-expected core CPI in Spain, significant easing in Germany regional CPIs and increased Italy PPI deflation. Tomorrow brings Eurozone CPI and US PCE for September.
The only fundamental justification for the recent backup in bond yields seems to come from the extended rally in crude oil and its assumed eventual impact on inflation expectations. Ten-year inflation breakeven yields ticked higher yesterday afternoon and are slightly higher this morning. In our opinion, technical factors and increased Treasury supply are more significant drivers. One of the ‘technical factors’ behind the backup is the idea that 10-year yields tend to line up with terminal Fed rates toward the end of the hiking cycle. Ten year yields are now 4.61% and terminal rates are 5.5%, which suggests the potential for even higher yields given the consistent higher-for-longer message from the Fed.
The bearish impact of higher bond yields on equity multiples is more acute when economic data rolls over. Equity markets tolerated rising bond yields in June as the US Economic Surprise Index (ESI) inflected higher and Portfolio Managers (PMs) were underweight cyclical equity sectors. Those conditions no longer exist and the impact of higher bond yields is weighing on equity markets. It’s possible that the data will once again inflect higher, but its more likely that the lagged effects of monetary tightening are now working their way through the economy. Monetary tightening always works with ‘long and variable lags’ and post-pandemic distortions may have extended the timeframe.
The US yield curve has now been inverted for 16 months. The statistical significance of curve inversion and a recession-driven bear market is difficult to prove given a handful of observations, but past episodes have taken 19-24 months to play out.
The S&P 500 (SPX) and Nasdaq 100 (NDX) are now oversold, which increases the likelihood of a relief rally as long as realized equity volatility remains contained. The CBOE Equity Volatility Index (VIX) remains contained for now at levels below 18. VIX levels above 22 are considered elevated and will act as a headwind for any rally attempts.