Weekly Perspective: Marvin and Janus – What the Bond Market is Saying and What it Means for Equities
There’s a great old vignette of Looney Tunes where Bugs Bunny finds himself stranded on Marvin the Martian’s space station (shockingly this time was not from missing that left turn at Albuquerque).
Bugs overhears Marvin’s plans to use his newly developed explosive device to remove a planet obstructing his view of Mars (presumably the first interstellar air rights dispute). When Bugs realizes that this pesky planet just so happens to be Earth, he quietly extinguishes the explosive and makes a run for it.
Marvin, not realizing the explosive has been snuffed and filched, remarks, “But where’s the KABOOM? Where’s the Earth shattering KABOOM?”
Interesting enough, “Where’s the KABOOM?” was also the bond market’s response to last week’s inflation data.
(Remember bond yields and prices move in opposite directions. We would normally expect bond yields to move higher when inflation is higher because the higher inflation makes bonds’ fixed income stream less attractive, causing bond prices to fall and yields to rise.)
Despite another upside surprise to CPI inflation and some measures even showing the most rapid change in inflation in 40 years (see Chart 1), long bond yields did not explode higher last week.
Instead, they declined to their lowest level since February and are now back near the pre-pandemic generational lows from 2012 and 2016 (see Chart 2).
We think there are few key observations to make about this reaction:
- The bond market agrees with the Fed that inflation is transitory:When peeling back the layers in the data, nearly 2/3 of the increase in headline inflation came from areas with distinct COVID disruptions (used car prices, rental car prices, hotel rates, and air fares, see Chart 3).There appears to be little to no contagion from these sharp increases into broader price data (CPI ex- food, energy, and transportation remains below 2019 levels, see Chart 4).
Further, the 2-year change in prices, which removes the “base effect” of 2020’s pronounced distortions, remains subdued versus history (see Chart 5). Outside of the COVID idiosyncrasies, inflation is not out of control.
The bond market is signaling that it believes that once these easy comparisons are lapped, and some near term supply disruptions are solved (how quickly that can happen… lumber supply now exceeds demand, causing prices to tumble more than 17% last week!), inflation will moderate back to lower levels.
This transitory view explains why bond yields can be so low despite higher inflation, with Chart 6 showing how much April and May of 2021 have
diverged from historical relationships.
- The bond market believes the Fed will not remove accommodation any time soon:With the Fed meeting for two days this week, there is little anticipation that the Fed will signal any change in policy given the underlying inflation data that appears to confirm the Fed’s transitory stance. Further, labor data has plenty of room to improve on the surface (despite statistics like jobs being hard to fill surging to new all-time highs, see Chart 7). The probability of a rate hike in 2022 fell last week (see Chart 8).The conclusion from point 1 and 2 is that the Fed better be right about inflation and keeping accommodation, otherwise there is likely a big recalibration of yields that needs to happen…
- The Fed’s persistent ultra-accommodative stimulus measures are still depressing bond yields:The Fed continues to buy $80B a month of Treasuries, while keeping policy rates low not only pushes investors out the maturity curve to get yield, but has also likely contributed to banks buying massive amounts of Treasuries for their reserve balances.All of this serves to dampen the price signal we can glean from Treasury yields, given there is a significant non-economic (meaning the Fed is not sensitive to price level) participant in this market.
- International yields are still an anchor on U.S. yieldsThis may be a chicken or egg situation, but the Japanese 10-year bond yield fell to 0.03% last week, the lowest level since January 2021. The German 10-year bund yield peaked in May and has fallen back to -0.26%.Low yields in other developed countries act to weigh down U.S. yields. If yields are falling internationally, it makes U.S. yields more attractive. This increases the demand for U.S. bonds, putting downward pressure on yields (upward pressure on prices).
- Positioning was very one-sided being bearish Treasuries and bullish on inflation/cyclicality, so some unwind can be expected:Traders, expecting interest rates to continue to press higher, had become very short Treasuries. This one-sided positioning is fertile ground for “pain trades” or prices that move in the opposite direction of the way that most are positioned.We can see this one-sided higher yields, pro-inflationary positioning through the flows into inflation sensitive areas of the equity market and commodities. There have been record inflows into these pro-inflation assets. Thus, we are not surprised to see a pause in the rapid ascent of commodity prices and would expect further weakness in the cyclical vs. defensive trade in the near term. The attached deck includes charts to show this dynamic.
- There appears to be some waning optimism on growth and incrementally less demand for risk-on assets:Falling yields can signal increased demand for safe-haven assets like Treasuries and falling growth expectations. The decline in yields has been primarily driven by falling real yields, not falling inflation expectations, which could reflect a more subdued growth outlook.We would see it as a distinct negative signal for the market and economy if yields continue to fall and break that important support from 2012 and 2016 that he highlighted earlier. We’re not seeing it yet, but certainly on watch.
Point #6 is very important.
It is consistent with our expectations for a more defensive posture for equity trading through the summer months, as falling yields can signal less risk-on appetite.
We also note the risk posed by complacent investor positioning and sentiment, with the put-call ratio returning to lows (signals investors are willing to pay more for upside optionality than downside protection) and the VIX at post-pandemic lows.
However, we are picking up on a lot of mixed signals from markets, meaning there isn’t a blaring “RISK OFF” message being sent at this time. For example, Utility stocks are not confirming the move lower in yields. Utilities continue to trade near relative lows vs. the market (Chart 9). This means that investors are not flocking en masse to the safest parts of the equity market, yet.
We call this the Janus market, because like Janus the two-faced Roman god of transitions and duality, the market appears to be looking in two different directions: risk-on and risk-off. We detail this concept in the slides attached, but for a short version see Table 1, which shows a comparison of these risk-on vs. risk-off signals.
Eventually these conflicting signals will resolve in one direction or another, but in the meantime, we see enough evidence to support a defensive posture.
The view remains: be patient when allocating to equities in the near term, as you may get a better price over the next couple of months. A correction with a magnitude of ~10% is well within the realms of possibility. This would bring us back to the 200-day moving average. A correction of ~10% does not necessarily justify raising cash if taxes are a factor, but it does justify being patient with new allocations.
We see signs of waning momentum in equity trading, so if the equity market continues to push unflinchingly higher, making new all-time highs on falling momentum, we may be inclined to expect a larger correction that warrants a larger response.
For now, we’re still listening for that KABOOM.
Table 1: The Conflicting Signals of the Janus Market
|Risk-On, Cyclical||Risk-Off, Defensive|
Source: Fieldpoint Private
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