When the bond market is getting destroyed why isn't the equity market?

Chris Weston
Head of Research
21 Mar 2022
Jay Powell has opened the prospect of a 50bp (0.5ppt) hike in the 5 May FOMC meeting.

Suggesting if warranted, that they’ll hike by 50bp and further take rates above the neutral rate (considered to be 2.40%) – this is already a projection detailed in the March dots plot. Still, Powell’s comments were more hawkish than his FOMC presser and he’s caused quite the stir in the bond market.

We now see the prospect of a 50bp hike in the next meeting (5 May) at 72% and while there’s some way to go until the May FOMC meeting, the marquee data points that could shape this are PCE inflation (31 March), US non-farm payrolls (1 April), CPI inflation (12 April) – while we watch market-based inflation reads, credit spreads and equity levels too.

Consider that we get the March FOMC minutes on 7 April and we’ll learn more about balance sheet reduction (QT – Quantitative Tightening), and there’s a strong possibility we should get the final decision on the size and composition of reductions in the May meeting (if not May then June) – so this sets up a mouth-watering proposition for macro heads that we get a 50bp hike and the formal announcement of a lower balance sheet to actually start from June or July – a huge event risk in the making.

Despite a huge 18bp move higher in 2yr US Treasury yields to 2.11% and yield curves headed ever closer to inversion, the S&P500 closed unchanged at 4461 and well off its lows of 4424. The NAS100 closed -0.3% at 14376 (lows 14190). The USD outperformed, but a 0.3% rally when US real rates were +12bp is a rounding error and incredibly gold rallied 0.7% – likely as some form of portfolio hedge.

The equity rally is of clear interest and we see in the NAS100 that there is solid support below 14k – when US 10yr Treasury (the discount rate that helps us derive a net present value) is spiking further above 2% and threatening to break the multi-decade regression channel we should consider why equities didn’t get smoked.

My own view on this is that funds are well hedged, there’s tons of cash on the sidelines and rotation is real – when crude is +6% you rotate into energy while staying defensive and increasing the portfolio weighting of utilities. When US realised inflation is running at 7.9% and forward inflation swaps are above 2.5%, cash can help preserve capital against equity drawdown, but it hurts, hedges cost money and US Treasury yields are trending higher – so where do you go?

If QE was designed to take duration out of the market and push people to max out the risk, QT is pushing us into quality areas of the market, but not out of the market – granted, we’ve seen a 14% drawdown (in the S&P 500) but stability is seemingly the order of the day as the market watches for the next play in the Russian invasion of Ukraine.

The fact is a Fed bringing out the big guns in May and using forward guidance to set the scene ahead of this may be welcomed by the equity market – they’ve weighed up the outlook and feel a credible Fed is a strong Fed, and higher rates are better than entrenched inflation – the bond market may be starting to send some warnings, but the prospect of a recession further out is still less than 20%, and perhaps we can hedge out this risk by being long gold. With household cash levels elevated, perhaps the consumer can absorb hikes, and what matters is the terminal rate which is below 3% is much lower than prior rate hike cycles.

I still think QT needs much more exploration in the market's eyes and what matters here is real rates – if equities are to take another leg lower then either we need a clear escalation in geopolitics and new highs in crude, China’s COVID-zero policy backfires and causes real concerns of China achieving its 5.5% growth target or US real rates throw a wobbly and head to zero. We’re not seeing the market breaking on higher rates at this stage.

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