October 10, 2023
Two weeks ago, the backup in bond yields disconnected from fundamental drivers of inflation expectations, growth data and Fed expectations. At 4.79%, ten-year yields were trading ~40bp above fundamental-implied fair value, which was a ~2.5z differential. Today’s rally in bond prices follows incrementally ‘dovish’ Fed comments that result in OIS markets repricing the probability of further rate hikes to ~16% from ~40% last week. Prices have rallied but fundamentals have also shifted, resulting in only a small narrowing in the disconnect between yields and fair value. Note that 10-year yields declined by at least 100bp following the final rate hike from the last eight Fed tightening cycles. If July was the last hike of the cycle, now is the time to add bond duration.
The 5/10 yield curve has improved to +5bp from a low of -36bp this summer. A positively sloped yield curve is preferred, but, in our opinion, the 5/10 curve needs to break above +19bp to change the trend. In past cycles, a change in the 5/10 curve trend has preceded a Fed pivot by 1-2 months. Fed comments from the last two days imply further rate hikes may not be necessary, but nowhere close to signaling imminent policy accommodation. Holding rates at current levels will keep 10-year real yields highly restrictive at levels above +200bp. The Fed’s recent change in tone follows the sharp backup in bond yields, which took the S&P 500 (SPX) down ~6.5% and the more cyclically sensitive Russell 2000 (RTY) down -14%. Unfortunately, getting to a Fed pivot will likely require a more significant repricing in assets. We may be in the early stages of a transition phase, where a decline in bond yields reflects rapidly falling growth expectations. In this phase, lower yields don’t help equity valuations.
The S&P 500 (SPX) bounces from oversold levels in a relief rally that will likely fade in coming days. The Russell 2000 (RTY) and equal-weight S&P 500 (SPW) were far more oversold than the cap-weighted SPX, and therefore seeing a bigger relief rally. We expect these indices will come under renewed pressure first, resulting in more crowding into mega-cap Tech. Crowding into stocks with the largest market capitalizations is a defensive dynamic that often precedes a broad market breakdown. The NYSE FANG+ Index (NYFANG) is in the middle of its bearish distribution pattern and has yet to break down. NYFANG levels below 7175 constitute a breakdown in our opinion, which is ~7% below current levels. A break in the NYFANG would correspond to the SPX breaking support near 4200 with accelerating downside momentum.