The Weekend Edition # 129 - Growth and Inflation driving Yields

Welcome to another issue of the Weekend Edition!

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Here's what we cover

• Market Recap - Markets Under Pressure

• Macro - Growth and Inflation Driving Yields

• Closing Thoughts - Not all Sectors are created eq …

• Calendars

Market Recap - Markets Under Pressure

April 01 - April 05, 2024

It’s been a volatile week for the US Markets brought on by geopolitical tensions and super hawkish Fed Speakers, insinuating that there just may not be any rate cuts this year.

We saw the S&P 500 index take out the 20-day moving average on Thursday but, thanks to the quick reversal on Friday, we’re back above it. Still, if this continues, it could be the start of a broader correction, seeing as how the market continues to remain overbought. We don’t expect a crash but, more a healthy correction.

While volatility also settled down somewhat on Friday, we saw quite a spike during the week. As far as options positioning is concerned, the market has flipped into negative gamma territory which is “chase mode” for dealers. Price moves in the market tend to be magnified during this time.

We also closed Friday at a key level, as you can see at 5204. It will be important to watch how the market reacts next week. We have a wall of worry to climb with all the macro data ahead - the FOMC meeting minutes, US CPI inflation data, and the start of earnings season, not to mention more Fed speakers.

Commodities

This week in commodities has been all about Oil, Gold… and Silver.

Silver jumped 9.6% over last week. There’s a classic late-cycle rally underway in commodities driven by the reflation trade and the overarching need to hedge geopolitical risks.

Gold hit $2350/oz and pulled back slightly into the close. While the close still looks quite bullish and overall momentum is positive, we are stretched here and there’s a lot of discussion that the fundamentals don’t support the price here. We could see a temporary pullback.

Base metals are expected to see support from recovering manufacturing activities and structural demand from China's emphasis on green metals.

Agriculture continues to remain bullish and this week we saw an increase in wheat prices, driven by short covering and tensions in the Black Sea region.

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Macro - Growth and Inflation Driving Yields

Last week, we talked about being cautious about yields, particularly at the long end. We saw exactly that play out this week.

During the week, we saw fed speakers come out with significantly hawkish commentary, going so far as to suggest that there may be no rate cuts at all this year. This obviously played on the short end of the curve, because the Fed Funds Rate (the rate set by the Federal Reserve) weighs more on the 2-year rate. In fact, traders have now pushed the first Fed rate cut out to September 2024 and are pricing in 0.57% rate cuts for 2024.

The last time we saw yields rise after June 2023, was because we saw higher-than-expected growth numbers coming out of the US and inflation spiking again at the headline level. The chart below marks this area in yellow.

We’re facing the same situation once again, with a re-acceleration in inflation and stronger than expected GDP growth.

Goldman Sachs presents a further granular view of this in the chart below (they always have some great charts!). As we can see, the drag from inflation has now reduced remarkably and will likely turn positive in the coming weeks. Furthermore, we’re seeing growth and policy continue to drive rates higher.

Treasury Issuances

The other issue that we talked about is treasury issuances. As the Fed gets closer to cutting, which we know they eventually will, we are likely to see more treasury issuances at the long end of the curve. Right now, we’re at the point where most of the issuance has been done at the short end, because that’s where rates are high enough to attract buyers.

This is what we call maturity mismatch. We hated this in corporate banking and it was always a red flag when a company borrowed short-term to finance long-term expansion. Well, that’s what the US Treasury has been doing, and at some point, they will have to stop.

When bonds are issued at the long end, the supply will increase pushing down prices. When bond prices fall, yields rise. Furthermore, if the yields are still not high enough, i.e., if the yield curve remains inverted, we’re likely to see buyers demand more term premium, which means they will want to get compensated for locking their money up long term.

Closing Thoughts - Not all Sectors are created equal

The yield curve steepening out to normal is usually when we’re likely to see a recession. It’s easy to freak out when you hear takes like this but, I think the US may just manage to avoid a recession and engineer that elusive soft landing.

Nevertheless, it certainly doesn’t bode well for long bonds, just yet, and to a certain extent long-term rate-sensitive sectors. This is why we remain cautious about small-cap growth.

Housing also falls within these parameters and will definitely see some pressure, but right now housing stocks are driven more by the demand for homes in the US than just rates.

The Fed seems determined to cut rates, even if it is slower than expected and slightly delayed. Even though we’re seeing inflation re-accelerate, it is perhaps not strong enough to deter the Fed from cutting rates. The other factor is unemployment, which remains at historic lows, but we are seeing some deterioration under the surface. A spike could speed up the process of rate cuts.

Finally, we’re seeing global growth data improve as well on the back of easier financial conditions. While in the short term, we see yields increase and the Fed remaining hawkish, the idea of a global easing cycle has set in and manufacturing activity has started to pick up again.

Global PMIs (activity data) have now moved from contractionary to expansionary - for both composite and manufacturing data. This is what is driving commodities and we expect this to continue, exacerbated by weather conditions, geopolitical factors, and structural under-supply.

Have a great week ahead!

Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers.

Calendars

US Earnings Calendar

US Economic Calendar in Eastern Time (Source: Trading Economics)

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.