Morning Notes — Terminal Rate

Terminal Fed rate expectations (implied in the OIS forward curve) have been the dominant driver for equities since April/May. Today’s downtick to 4.87% from 5.01% yesterday is a step in the right direction with levels closer to 4.75% required for the S&P 500 to push toward resistance at ~3900. Note that equity cross-market relationships tend to be fleeting, but terminal rate expectations will likely dominate equity direction until the Fed signals a pivot.

Contrarian: Net flows from Hedge Funds returned to YTD lows last week and two weeks of persistently heavy retail investor selling matches levels from the June lows and those from March ’20.  The S&P 500 (SPX) won’t officially break its downtrend until it clears ~3800 but we see an increasing likelihood for this to happen given nearly unanimous bearish sentiment.  We also gain conviction that the Q4 rally is now underway based on momentum factor outperformance returning to YTD highs two weeks ago.  The momentum factor has had a negative correlation with broad market returns since late-Q1.

Buyers are higher: Hedge Fund (HF) alpha spreads widened out in September as managers learned on short positions. Short-covering rallies happen all the time but tend to be most acute when managers need to protect performance into year-end.  At the end of the day, getting to higher levels requires the cooperation of fundamental factors with lower terminal rate expectations presently carrying the most weight.