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Inside Markets — Volatility and Breadth

Bond Duration

February 26, 2024

OIS markets are now priced for 70bp of rate cuts in CY’24, which is now lower than the 75bp from the Fed’s dot plot.  For the time being, equity markets have seemingly uncoupled from the direction and scale of market-based rate expectations.  The SPX has gained ~6% as FY’24 rate cut expectations have fallen nearly 100bp since mid-January.  This is because the repricing of rate expectations is partially perceived to be a result of resilient economic growth with US and global flash manufacturing PMIs moving back to expansion territory in January.

The current ~21x forward multiple on the SPX only makes sense as long as realized volatility remains contained. Low levels of realized equity volatility have been the byproduct of a benign macro environment characterized by declining rates of inflation, resilient growth and an eventual Fed policy pivot.  Fed rate cuts as a response to declining inflation have historically been bullish for equity markets, but rate cuts to counter a growth scare have had bearish equity implications.  A negative non-farm payroll print would likely generate stagflation concerns, spike realized volatility and create a bearish repricing in the forward SPX multiple. You’d get a similar reaction from 3 consecutive negative retail sales prints. Recall the January retail sales number came in at -0.8%, down from +0.4% in December.  An inflation spike from here that pushed bond yields materially higher would likely drive bond volatility higher, which could then spill into equity markets like it did in 2018.  Volatility as measured by the CBOE Equity Volatility Index (VIX) remains subdued and equity-friendly at ~14.  VIX levels north of 20 become a headwind for rally attempts and levels above 30 generally lead to accelerating downside momentum.

Narrow leadership remains the only red flag for the recent rally. The rally has shown signs of broadening out since November, but prior attempts to move beyond technical thresholds have all failed.  The equal weight S&P 500 (ETF symbol RSP) is very close to its January ’21 all-time high.  An RSP break above ~$164 would be a bullish broad market signal.  The cyclically-sensitive Russell 2000 (RTY) is making another attempt to break through intermediate resistance in the 2000-2100 range.  A sustained close above ~2070 with confirmation from cyclical cross markets would also have bullish broad market implications.

Ten-year Treasury yields have bullishly reversed from easy-to-identify technical resistance levels near 4.32%.  The recent backup from ~3.80% has always looked like counter-trend mean reversion amid a developing bull market for bond prices. Current levels are a reasonable place to add bond duration with increased conviction once 10-year yields move back below 4.02%.

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