One of the biggest anomalies so far this year is how calm the U.S. stock market has been while gyrations in bond yields have been unusually large. As shown in the charts below, fluctuations in two-year Treasury note yields are the largest since the 2008 Financial Crisis while stock market volatility as measured by the VIX index is the lowest since the Covid-19 pandemic struck.
The VIX Index
The heightened bond volatility is straight forward: It reflects surprises about the U.S. economy and banking system. The economy began the year on much stronger footing than investors anticipated when the January jobs report posted a 517,000 increase in non-farm payrolls, and data on consumer spending was stronger-than-expected. At the same time, readings for both headline and core inflation were well above the Federal Reserve’s average annual target of 2%.
The yield on the two-year Treasury note surged to 5% on March 7, the highest level since 2007, when Jerome Powell signaled that the Fed could raise interest rates by 50 basis points in his congressional testimony. According to an Axios report, global macro hedge funds were overwhelmingly positioned for the Fed to keep raising rates aggressively until inflation was brought under control.
What transpired next was a complete reversal as Silicon Valley Bank (SVB
As the shock over deposit flight from banks has sunk in, investors are now focusing on whether problems with regional banks will tip the economy into recession. At the press conference following the March FOMC meeting, Jerome Powell acknowledged that banking problems could reduce lending, but he maintained the Fed’s paramount goal is to reduce inflation. The Fed wound up raising rates by a quarter point, and it is expected to follow with another 25 basis point hike this week.
Amid this, the stock market has taken developments in stride: The year-to-date return for S&P 500 is more than 9%, although much of the increase is accounted for by a handful of tech stocks. The principal reason is that investors believe the Fed will pause in raising interest rates after this week and that it will lower rates in the second half — the so-called “Fed put.” Indeed, there is now about a 75 basis point difference between where the Fed believes rates will end this year and where the market does.
One development supporting this view is that in the wake of the regional bank problems the Fed added to its holdings of bonds to help drive yields down. This could be a precursor of how it will behave if the problem spreads.
Conversely, what could cause the stock market to break out of its narrow trading range since mid-2022 and sell off?
One possibility is that inflation could turn out stickier than investors perceive. If so, even if the Fed pauses, it would only be temporary because the Fed wants to retain its credibility as an inflation fighter. If it were to raise the funds rate to 6%, for example, this would add to bond market volatility and likely spill over to the stock market.
Another possibility is that corporate profits will weaken by more than what is priced in to the stock market. The impact of slower economic growth on corporate profits was evident last year, when the S&P 500 operating earnings per share slowed to 5% and declined by 3% in the fourth quarter. The consensus view among Wall Street analysts this year is that EPS will level off. However, firms that are forecasting a recession such as Morgan Stanley
Weighing these possibilities, my take is the worst outcome for the stock market would be continued high inflation. The reason: It would compel the Fed to tighten policy further and would risk a more severe recession than is now being priced into markets.
By comparison, a mild recession would likely have only a temporary adverse impact on the stock market, because investors already appear prepared for one. If history is any guide, the stock market typically rallies once the trough of a recession has been reached. This reflects the effects of both lower interest rates and an improved earnings outlook.
What investment strategy makes sense in these circumstances?
At Fort Washington Investment Advisors, we are maintaining a cautious stance towards equities because we do not expect the Fed to ease policy significantly this year. At the same time, with the sell-off last year valuations have adjusted to more normalized levels and earnings expectations have come down. Accordingly, we are prioritizing companies that have high barriers to entry with high returns while maintaining a defensive posture overall.
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