March 15, 2023
Bond market volatility has spilled into equity markets and other cross markets amid low liquidity conditions. Implied equity volatility as measured by the VIX Index is pressing toward levels from last September. Increased equity volatility usually results in a higher risk premium and acts as a headwind until it subsides. Volatility spikes often take a few months to subside, even when the original source is no longer present.
The debate over whether the Fed prioritizes inflation or financial stability at next week’s meeting seems unnecessary. Financial stability is the priority. The Fed will likely hike rates by 25bp next week, but what’s occurred over the last week will lead to a collapse in credit creation at banks and inflation will cool absent additional supply shocks. Equity markets shouldn’t rally on this as a collapse in credit creation also results in economic weakness and more systemic risk for the banking system.
A bullish equity outlook first requires a period of increased pain to create accommodative policy, expanding money supply and then a cyclical recovery. Equity markets will bottom before the Fed pivots and well before the economy improves. A positively sloped 5/10 yield curve would be the earliest signal of an imminent Fed pivot, but a more constructive equity outlook only requires confirmation of a bottom in the current curve inversion. Fortunately, the current inversion of -11bp is very close to confirming a bottom with sustained levels above -8bp as the new target. Unfortunately, a confirmed bottom in the yield curve tends to precede a bullish inflection in equity markets by a few months.