August 7, 2023
Last week’s pullback in equity markets was driven by a volatile week in the bond market. The volatility may have been partially sparked by the US debt downgrade, but its impact on US sovereign Credit Default Swaps (CDS) was minimal at ~1.5bp. The majority of the volatility in bond markets followed the Treasury’s quarterly refunding announcement that it needed $258B more than forecast. The Treasury also announced that future auction sizes would increase. At one point last week, 10-year Treasury yields rose 23bp, taking the MOVE Index from 115 to 125. Implied volatility in the stock market often starts in the bond market. Implied equity volatility is measured by the VIX Index with levels north of 22 becoming a headwind for sustained rallies. In the current environment, we estimate that a MOVE Index greater than 145 would likely push the VIX above 22 from its current level of 16.
There are only three major macro catalysts remaining for the month of August: 1) July CPI this Thursday; 2) PPI on Friday and; 3) Jackson Hole on August 24-26. Consensus is looking for headline and core CPI to print the same level as last month at +0.2% MoM. This will likely result in a YoY increase as base effects become a headwind going forward. Knowing this, the Fed will likely focus on the MoM rate into the September 20 Fed meeting. We see a slightly higher probability for a dovish July CPI print, but expect the August CPI report to have greater influence over the Fed’s September 20 policy decision. The Jackson Hole summit and September 20 Fed meeting are the most likely events where the Fed could announce an end to the hiking cycle. An announced end to the Fed’s hiking cycle should result in lower bond yields and curve steepening, which would make the current SPX forward multiple of ~18x a bit less conspicuous. Without market pressure, the Fed will likely choose to preserve its optionality as long as possible, resulting in a ‘nothing done’ at Jackson Hole. Policy ambiguity during a weak seasonal period has the potential to result in softer equity markets as we return from summer holidays. Feeling a little market pressure and faced with in-line to weaker inflation data, the Fed may be more motivated to announce the end of its hiking cycle on September 20. The S&P 500 maintains a bullish bias at levels north of 4325, which is ~4% below current levels.
The 5/10 yield curve has steepened into technical resistance levels between -7bp and -9bp. We look for that level to hold for the time being with an eventual break above +18bp as our signal for an imminent Fed rate cut. Unfortunately, this may not happen until we’re well into 2024.