As the equity market rebounds, there is a growing concern on Wall Street regarding the increasing correlation between stocks and bonds, especially as two-thirds of the S&P 500 now move in tandem with yields, reaching levels not seen since 2001, according to data from Societe Generale SA.
Despite a 1.8% weekly gain in the US benchmark, recent mixed signals from the oil market and consumer prices raise questions about whether bond yields will be a friend or foe to traders in rate-sensitive strategies. The market’s sensitivity to bonds stems from the expanding valuations observed last year, leaving equities vulnerable to unforeseen outcomes in the path of Federal Reserve policy.
Andrew Lapthorne, SocGen’s head of quantitative research, highlights the significance of bond yields, stating that without a substantial decrease, a large portion of the market faces a significant valuation headwind. The current positive correlation between stocks and bonds, reaching a near-record 66% of the S&P 500’s market capitalization, prompts warnings that investors in small-cap stocks and junk bonds may face disappointment due to lower-than-expected rate cuts and corporate profits.
Despite concerns, traders are currently pricing in around six quarter-point rate cuts for 2024, twice what the central bank projects, with expectations of the first rate reduction as early as March. This contrasts with views expressed by Loretta Mester, president of the Fed Bank of Cleveland, who suggests that cutting interest rates in March may be premature, emphasizing that inflation data indicates policymakers have more work to do.
While positive stock-bond correlations are leading to contrarian views, concerns persist about the potential disappointment for investors venturing into risky assets. The rally in megacaps in 2023 has left an increasing portion of the benchmark index tied to long-term earnings prospects, making it more sensitive to rising yields.
As the Federal Reserve navigates the path to bring inflation back to the 2% target, data showing an unexpected decline in producer prices conflicts with the slightly hotter-than-forecast consumer version. Inflation concerns linger, influencing positive stock-bond correlations and raising the bar for potential interest rate cuts.
For Marija Veitmane, senior multi-asset strategist at State Street Global Markets, the stock market lacks compelling reasons to rally in the medium term, and the rally seen in December 2023 may have borrowed from this year’s potential gains. Shifts in positioning and sentiment from risk-off to risk-on at the end of 2023, along with reduced expectations for hawkish surprises from the Fed, indicate a complex market environment.
Max Kettner, chief multi-asset strategist at HSBC Holdings Plc, suggests that most of the positive news has already been priced in, and a dangerous mix of stretched investor sentiment and positioning, along with stretched central bank rate pricing, poses risks. Kettner emphasizes the need for yields to fall further to bring interest-rate volatility down.
In conclusion, the intricate dance between stocks and bonds, influenced by inflation worries and Fed policy, remains a focal point for investors navigating the complexities of the current market landscape.
