I ran across this chart yesterday (a retweeet from 13D Research and Bloomberg), and I thought it was interesting because we had some unusual price action Friday. Normally, when equities drop almost 1%, you would expect fixed income to rally noticeably (especially after the volatility-driven market nervousness earlier in the year). But the long end of fixed income actually sold off noticeably! I suppose the longer end of the yield curve did (over)flatten the prior few months, so perhaps we were due for a correction.
Since the volatility scare a couple of months back, it’s felt like fixed income has been more reactive to the direction of equities. It was interesting to see a chart that shows a bigger picture view of what happens before a large equity downturn. I would have thought that because of the “predictive” power of the yield curve, fixed income would start rallying (and/or flattening in the long end) before equity downturns. But in fact, right before most major equity corrections, longer end fixed income yields rise noticeably over a number of months. Ten year yields made a new multi-year high on Friday, and yields have been increasing since last September, so we met the criteria of yields rising noticeably over a number of months.
Perhaps yields rising before a stock market correction has something to do with the Fed being overconfident and subsequently overhiking. It just so happens that the past few weeks, we got a large dose of Fed confidence in the economy. I’m not convinced the Fed won’t be more cautious this time around – especially since the Fed has hiked us into recession many times in the past.
I have noticed the past few weeks that when analysts come on the various media outlets, they are generally supportive of equities, but the one factor they usually cite as a “concern” for equities would be if we got some combination of higher inflation and higher rates (typically the ten year above 3.05%). As a baseline, we are expecting higher inflation this spring for technical reasons (last year’s mobile phone rate increases dropping out). We also have higher oil and higher commodities, which could feed through to final goods. Finally, a number of the Fed speakers have suggested we will continue to get gradual rate hikes.
Part of the equity selloff could be the risk of higher rates affecting equity valuations. Maybe. While I can see strong pattern on the chart, we are talking about 3% yields. That’s still nothing! When companies do IRR (internal rate of return) calculations for projects, I really doubt the difference between 2.5% and 3.0% yields (plus a spread) matters at all.
I’m a little befuddled as to how rates could rise before an equity downturn. The chart indicates that fixed income does rally when the equity correction happens… I just didn’t realize we usually had a sharp rise in yields before the equity correction. But I have been calling for equities to be weaker in Q2 for some time, so perhaps this selloff could give us a good opportunity to get on some good risk/reward longs in fixed income. Bullish trades are the topic of the Trade Thoughts section this week.