May 23, 2022
A sustained rally in equities requires lower inflation breakeven yields followed by lower nominal bond yields and lower Fed expectations. All three have come off recent peaks, but it started with breakeven yields cracking below 280bps on May 9. Some of our cross market indicators stopped working after retail investors crowded into a relatively thin TIPS market following the 2/24 invasion in what looked like inflation panic. The normal collinearity between nominal yields and Fed expectations broke down when 10 year TIPS breakeven yields moved through November’s cycle high of ~280bps. The move through ~280bps occurred on March 7 with Fed commentary sounding sharply more hawkish thereafter. In a normal functioning market, the hawkish tone would lead to lower longer-dated nominal yields. But markets weren’t functioning normally/rationally and hawkish Fedspeak led to higher long-dater nominal yields. Bond market volatility (MOVE Index) rose sharply and so did equity market volatility (VIX Index). More needs to be done, but we see 10 year breakeven yields settling into the 258-260bps range with 30-year nominal yields finding a home closer to 2.82%. If that happens, we’d expect terminal Fed fund expectations to fall closer to 2.50%, which would bring lower bond and equity market volatility. The VIX currently sits at 28.5 (down from 35.5 recently) and levels below 20 mean that volatility is no longer a headwind for equities. Markets will trade better on the approach to 20.