This year has been particularly challenging for consensus positioning and beliefs – “it’s transitory to soft landing” now being hit by “higher-for-longer.” This has also contributed to some unusual or atypical price action, especially in the bond market. As we noted last week, the irony of the consensus belief in soft landing and higher-for-longer rates is that has come just as macro conditions have started to deteriorate, especially with respect to most leading indicators of the labour market (chart 1).
Historically, the labour market has been critical to the Fed’s reaction function. Again, the irony is that the Fed was oblivious to inflation risk in 2021 and early 2022. Back then the Fed had inflation denial and promoted a transitory narrative. At the September 2023 FOMC renewed growth hype has been factored into forecasts. Now the Fed is probably underappreciating recession risk. Clearly the backward-looking data has been resilient likely supported by the extraordinary fiscal thrust in the first half of the year. However, the consequence of aggressive fiscal policy has likely been the renewed rise in Treasury yields, mortgage rates, corporate bond yields and the dollar. Put another way, fiscal easing (at full employment) and a shift to “fiscal dominance” has contributed to renewed tightening in broad financial conditions.
In that context, recent price action in the bond market has been curious, particularly relative to equities. In recent recessions or growth scares bonds have outperformed equities (bond prices rise/yields fall, and equity prices decline). However, in the current episode, US equity prices have outperformed bonds despite the deterioration in growth. To be fair, goods and manufacturing weakness has likely exaggerated softness in the broader economy relative to past cycle (services and the labour market have been resilient compared to past cycles). Moreover, the current episode is an “inflation-driven” bear market in contrast to a typical growth shock. Therefore, the correlation flip between equities and fixed income might be a rational response to the current cycle.
However, from our perch, the forward-looking risk is that the typical relationship between bonds and equities resumes if or when growth and demand for labour deteriorates. If the best leading indicators of the labour market are correct, the bond market ought to start contemplating rate cuts by the end of this year. Stated differently, we have a quarrel with higher-for-longer. More likely, the markets will have to begin contemplating a growth scare and rate cuts.
The final point to note is that yield curves tend to un-invert just before a recession or when something breaks. Moreover, once the Fed eventually contemplates rate cuts, there is probably a meaningful risk to growth and profits. That is typically not bullish for equities. Especially when the earnings yield and risk compensation is inferior to Treasury yields. The irony is that after a 3-year bear market, bonds have probably become an attractive hedge or diversifier for equity again.