From the Desk of Steve Strazza @Sstrazza
Markets have been on the ropes since late last week when a Silicon Valley Bank press release sparked a run on regional banks.
As Wall Street scrambles to reprice the financial sector — for what, up until last week, were unforeseen risks — selling pressure and panic is spreading to Europe and other parts of the world.
Regulators are taking action. And the Fed is taking notice as expectations for future rate hikes plummet.
While Bitcoin and tech stocks have performed exceptionally well through the volatility, cyclical stocks and commodities have been hit hard, with energy and the CRB Index breaking to new lows this week.
What are we to make of all this? Should we be concerned?
Is the regional banking crisis a contained event, or is it about to send reverberations through the broader market and economy?
Whenever we have questions like these, the first place we want to look is the bond market.
Any signs of stress tend to show up there first.
Let’s analyze the recent price action and see how things are holding up.
The first and most important point we need to make is about bond market volatility.
Regional banks are not the only area that have been on a wild ride since last week. The bond market has seen a historic level of volatility.
Here is the bond market Volatility Index $MOVE overlaid with the stock market Volatility Index $VIX:
We haven’t seen this kind of volatility from bonds since the great financial crisis!
The reason we’ve overlaid the two is because it is rare to have volatility from one asset class without the other. Just look at how closely these lines track one another throughout history.
Now, look to the right-hand side of the chart and notice the recent divergence.
This tells us that if bond market volatility doesn’t cool off and come down fast, equity markets will have some catching up to do. This is likely to mean further – and broader, selling pressure for stocks.
The next chart shows the US 2-Year Yield with the nominal rate of change shown in the lower pane:
When banks started failing last week, it became very clear that the Federal Reserve had finally broken something. The market’s response to this was to dramatically readjust expectations for future rate hikes.
The terminal rate has come down considerably, and the odds for the March meeting are now suggesting 25bps instead of the double-hike that was priced in just last week.
Huge momentum thrusts like this tend to occur at turning points in the trend. As such, evidence is starting to build in a big way that the peak for interest rates – at least for this cycle – is behind us.
We’re watching those pivot lows and June 2022 highs in the US 10-Year and 30-Year for confirmation.
A decisive violation of these critical levels would indicate the path of least resistance is now lower for interest rates.
And what does this all say for inflation?
Well, it looks like maybe the fed finally broke that, too.
Not only is the CRB Commodities Index making new 52-week lows, but the 5-Year Breakeven Inflation Rate just experienced its largest 5-day decline since early 2020.
We’re watching the pivot lows in this chart. If those break, you can kiss inflation goodbye.
Last but not least, here is a look at treasury spreads.
The 2s/10s spread just experienced its largest move since the early 1980s, snapping higher by about 60bps over the trailing five sessions.
Isn’t that a good thing, though? Inverted yield curves are leading indicators for recessions. Does this mean we’re in the clear now? Maybe the two quarters of negative GDP last year was the recession, and it’s behind us.
When we overlay the 2s/10s spread with the S&P 500, it paints a darker picture.
When the treasury spread reversed higher from negative territory in the past — 2001, 2007, and 2020 — historic bear markets were just getting started. In fact, the stock market literally crashed following the last three inversions and subsequent reversals in 2s/10s.
We’re not saying that has to be the case again this time. Surely, it’s a different interest rate environment today than it was back then.
But we are confident that bond market volatility is never a good thing for risk assets or the stock market at large.
Seeing as the volatility index, short-term treasury yields, inflation expectations, and treasury spreads are all showing extreme levels of bond market volatility right now, a more cautious approach is prudent.
With that said, if we’re going to see equity market volatility anything like what happened after the inversions around the dot-com crash and financial crisis, it will show up in price. We’ll move safely to the sidelines when it does.
For now, stocks are holding up just fine, buoyed by relative strength in growth and tech since last week.
We’ll continue to listen to the message of the bond market as the dust settles around the recent banking crisis.
Countdown to FOMC
Here are the target rate probabilities based on fed funds futures. After last week, the market is only pricing in 25bps at the March meeting.
Click the table to enlarge the view.
Thanks for reading. As always, be sure to download this week’s Bond Report!