July 10, 2023
Friday’s softer non-farm payroll number was the first miss after 14 consecutive months of hotter-than-expected readings. This has helped front-end bond yields to come off recent highs, resulting in curve steepening and more cyclical equity outperformance vs. mega-cap Tech. The latter group is also under pressure as 10-year real yields reached multi-decade highs on Friday. The subtle twisting of the yield curve on Friday resulted in a 17.9% uptick in the MOVE Index, which measures bond market volatility. This resulted in some upward pressure in the VIX index to 14.83 after setting a 52-week low on June 22. A subdued VIX index has been a tailwind for equity rallies since it broke below 20 back in late March. In our opinion, implied volatility becomes a headwind for equities when the VIX maintains closing levels above 22. China fiscal stimulus that causes a commodity price spike seems like the most potent catalyst that could drive volatility higher in the near-term. However, we see this as a low-probability event given recent weakening in the yuan from widening interest rate differentials.
June CPI this Wednesday will be one of the key catalysts for the summer. We look for another chunky decline in YoY headline inflation to 3.2% from 4% in May, while the core rate dips to 5% from 5.3% last month. A more dovish headline number seems more likely than a hawkish print. We’re assigning a 45% probability to something in the 3%-3.2% range, which should result in 50-75bp of upside for the S&P 500 (SPX). Something between 2.8%-2.9% is a 25% probability in our view, and would likely result in markets pricing out a July rate hike. An outcome like this would result in the SPX pushing toward the upper end of technical resistance near 4535.
A June CPI print north of 3.2% would likely keep the Fed on track for a July rate hike, which we expect would be the last of the tightening cycle. A May or July end of the tightening cycle should be favorable for equities given expectations for lower bond yields, subdued volatility and tighter credit spreads. This scenario would also result in curve steepening and cyclical sector leadership during Q3. Positioning is no longer a tailwind but elevated levels of sidelined cash keep the near-term pain trade skewed higher.