Yield Curve Trends and Equity Market Corrections

At 88 bps, the term premium is well above the financial repression era lows of the past decade, but it remains well below levels that we might consider normal over the past 5 decades. My guess is that the term premium is on its way to 150 bps or so, which depending on what happens to inflation expectations could push the 10-year well above 5%. The stock market will not like that, and neither will the dollar. Why does this matter? For two reasons. One, as the stocks/ bonds correlation chart shows below, the higher yields go the more correlated bonds tend to become to equities. The purple dots show the correlation of long-term Treasuries to the S&P 500 (going back to the 1930’s) and the black circles highlight the period since 2020. The Great Moderation Era of the 2000’s and 2010’s is likely over, and we are back to the more traditional era of the 1960’s-1990’s. Two, the more correlated bonds are to equities, and the more competitive bond yields become to equity yields, the more impact those rising yields have in forcing equity valuations to correct. That’s at the heart of the Fed model, favored by the Maestro Alan Greenspan during the 1980’s. The model only works when rates are not being suppressed by central banks through zero interest rate policy (ZIRP) and Quantitative Easing (QE). The bond vs equity valuations chart and the DCF grid both indicate that a return to 5% for the risk-free rate could force the equity P/E-multiple to drop 3-4 points from here. That would be a 15-20% haircut to price, before adjusting for the offset from earnings growth. That’s consistent with the trading range thesis.

The correlation between stock prices and bond yields has returned to positive territory -- hinting at a period of distress in equities and a regime shift in equity and bond markets where recession fears, rather than inflation, may be starting to drive direction of both. The correlation between the two asset classes was positive for the better part of 20 years prior to the pandemic, suggesting equities trended in the direction of yields as inflation mostly coincided with growth. Stocks held a negative correlation to yields throughout most of the 1980s and 1990s, when inflation hurt stocks -- and that phenomenon returned for the 2022-24 bear market and recovery period. Notably, major stock corrections occurred each time the correlation jumped out of its primary regime. Bloomberg Intelligence Michael Casper, CFA

🔮 The Steepening Yield Curve Has A Message About Stocks An inverted yield curve has long been Wall Street’s crystal ball, foretelling recessions with an accuracy that could make Nostradamus green with envy. Issue is, it won’t tell you when the recession will hit. For that, you’ll need to pay close attention to when the curve begins to steepen again, particularly if it’s still upside down. This telling change could happen either because short-term rates begin to drop faster than longer-term ones (that’s a “bull steepening”, because falling rates usually boost bond prices), or because longer-term rates start to rise faster than shorter-term ones (that’s a “bear steepening”). If the steepening is driven by the former, it’s likely because markets are bracing for the central bank to slash interest rates in a near-frantic effort to stave off an economic meltdown. If it’s driven by the latter, it typically suggests investors are getting cold feet about longer-term debt, possibly because of higher risks of inflation or default. Both have had a knack for correctly predicting an approaching recession – and, as often, an upcoming dip in stock prices. I’m sharing this now because lately, the curve hasn’t just been inverted, it’s been getting steeper. And, look, that steepening has stalled a bit recently, but if it kicks into gear again, you can take that as a strong heads-up from the markets. Now, sure, the economy’s driven by a laundry list of factors – and this inverted-but-steepening signal isn’t foolproof. It could be ringing the bell too soon, say, or it could be sounding a false alarm. Maybe this time actually will be different, as those famous last words often go Still, I tend to think it’s better to play it safe. So consider this a friendly nudge to revisit your investments and make sure you're not overly tilted toward the riskier stuff. > Finimize

Ahead of the Fed's rate decision tomorrow, the bond signals that matter most for equities' direction are hinting that economic growth rather than disinflation trends will plot stocks' path for the foreseeable future. Key will be the Fed's ability to revitalize an economy that has been sluggish and uneven at best. The correlation between stock prices and 10-year treasury yields shifted positive shortly following the "liberation day" announcement -- regime flips have historically been met with periods of indigestion for equities. A positive stock price/bonds yield correlation means equities follow economic growth forecasts while negative regimes highlight that inflation concerns are at the forefront of investor mindset. Likewise, unusually narrow yield curves (both 10-2 year and 10 year - 3 month) fail to confirm a strengthening economic backdrop necessary to support small cap, value and cyclical stock leadership. Everything starts with tomorrow's rate decision -- treasury consensus sees a bull steepening across both curves through this time next year. If that comes to fruition, it could add support to the ongoing equity rally. Christopher Cain, CQF, CMT https://lnkd.in/e64dFMdZ