Fynsa
So far, markets have been able to live with higher interest rates this year because the mix of economic data has been favorable, with upside surprises in activity and downside surprises in inflation, and upward revisions in expected company earnings as recession risks recede have done the rest of the work.
This has allowed the correlation between interest rates and US equities to turn positive since March, and helps to understand the disconnect between historically stretched valuations and real interest rates trading at this cycle's highs.
But something has been changing in recent weeks. Markets have once again become more sensitive to the upward trajectory of interest rates, or, put another way, correlations between equities and interest rates have turned negative, as they were for much of 2022 and through March of this year.
It has been a turbulent few weeks for bonds, with the 10-year U.S. Treasury rate reaching its highest level since Nov. 2022, above 4.2%, while rates on the short end of the curve have been rather flat. While some of this renewed interest rate pressure on the long end of the curve reflects concerns about a U.S. downgrade by Fitch Ratings and a flurry of bond sales by the Treasury to cover the federal deficit, has also been driven by speculation that a resilient economy (the US grew by 2.4% in 2Q23, after growing by 2.0% in 1Q), will prevent inflation from gently returning to the Fed's target, given still-high levels in underlying indicators and longer-term expectations that remain more rigid.
In other words, what has been pushing interest rates is an increase in the term premium, which also implies a steeper curve.which also implies a steeper curve. With short-term inflation breakevens (up to 2 years) anticipating a more benign inflationary backdrop, longer-term inflation expectations are saying something different and remain elevated, longer-term inflation expectations say something different and remain elevated, and as the charts below show, this generally leads to an increase in the term premium and thus higher interest rates.
Moreover, the moderate levels of term premium also seem inconsistent with the degree of inflation uncertainty that still persists. Inflation volatility remains high.
So then, Treasuries look likely to fall again if it becomes clear that inflation is not dead, just dormant. Stocks too, as the rally continues to be driven by sectors and longer duration stocks.
At the moment, markets are in a delicate equilibrium and it will take some time to have a more conclusive opinion regarding the future path of inflation, but the movements of the last 2 weeks are a good reminder that the US market in particular does not have much room for error and prices near perfection (the S&P 500 trades above 20x PU fwd and offers a premium of only 100 basis points over 10-year Treasuries).
Some upside surprise in inflation, some poorly absorbed treasury auction, Japan losing control of the yield curve and the still limited market correction could be deeper.
If you are looking for guidance, just monitor the trajectory of interest rates closely.
