More stocks and bonds are moving in tandem, worrying some on Wall Street

BEHIND the scenes of a rebounding equity market are stubborn signals that anything short of a quick death for inflation spells big trouble for traders.

It’s visible in the growing sensitivity of large swaths of the market to bonds, with two thirds of the S&P 500 moving in unison with yields – doing better when rates fall and vice versa. That’s the most since 2001, according to Societe Generale SA data.

After a wobbly start to 2024, investors remain steadfast in their bullish conviction, with the US benchmark closing out a 1.8 per cent weekly gain. Yet mixed takeaways from the oil market and consumer prices this week raise the obvious question of whether bond yields will prove a friend or foe to traders across rate-sensitive strategies. The continued vigor of the business cycle arguably provides limited cover for Federal Reserve Chairman Jerome Powell to go all-in on dovish monetary policies, the warning goes.

At the heart of the matter for equities are valuations, whose expansion last year has left them especially vulnerable to unforeseen outcomes in the path of Fed policy. Wall Street bulls who powered a massive rally to close out 2023 have little room for error should inflation prevent Powell from easing policy significantly in the coming months.

“Without bond yields going down a large chunk of the market has a significant valuation headwind,” said Andrew Lapthorne, SocGen’s head of quantitative research. “We have a lot of market capitalisation that is expensive, and this is creating a positive correlation to bonds.”

Count Loretta Mester among those who think it’s premature to consider cutting interest rates at the March meeting. The Fed Bank of Cleveland president said Thursday (Jan 11) that inflation data suggests policy makers have more work to do. 

Yet traders are currently pricing in around six quarter-point rate cuts for this year – double than what the central bank projects – and betting that the first rate reduction may come as early as March. On Friday, Barclays shifted its forecast for first interest-rate cut from June to March.

As traders tank up on on risky stocks, bonds and credit, any hawkish warnings are sounding more contrarian by the day – but no less insidious. A near-record 66 per cent of the market capitalization of the S&P 500 is showing an elevated positive correlation to bonds, according to a Societe Generale’s analysis.

All that is spurring warnings that investors plunging into the likes of small-cap stocks and junk bonds risk disappointment on lower-than-expected rate cuts and corporate profits. That’s just as Corporate America’s earnings season gets underway. 

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A double-digit stock rally led by megacaps in 2023 means an ever-enlarging chunk of the benchmark index is acutely tied to long-term earnings prospects – and hence more sensitive to rising yields. After shares and bonds rose together last quarter, both are off to mixed starts. The S&P 500’s jump this week was only enough to leave it flat since the new year. 

Fed officials face a bumpy path bringing inflation back to the 2 per cent target. While data Friday showed unexpected decline in producer prices, the more-scrutinized consumer version came in a little hotter than forecast a day earlier. Rising shipping costs and a surge in oil prices are stoking fears among some about a revival of inflation pressures.

“Thursday’s CPI report demonstrates that while inflation is broadly in retreat, the pace of that retreat is slowing,” Michael Purves, the founder of Tallbacken Capital Advisors, wrote in a note. “The bar for cuts is simply a lot higher than it might have appeared after the December FOMC.”

With inflation concerns lingering, positive stock-bond correlations have firmed back up. The 60-day correlation between the S&P 500 and benchmark Treasuries turned positive again and has threatened bonds’ hedging role since August of last year.

For Marija Veitmane, senior multi-asset strategist at State Street Global Markets, this leaves stocks without many good reasons to rally in the medium term.

“December 2023 rally has borrowed from this year’s,” said Veitmane. “Strong data would spook the market into believing that rate cuts are not coming, while too weak data would get people to worry about recession.”

Positioning and sentiment rapidly shifted from risk-off to risk-on at the end of 2023. Investors have also slashed expectations for hawkish surprises from the Fed this year, Bank of America’s latest monthly sentiment survey shows. 

For Max Kettner, chief multi-asset strategist at HSBC Holdings, most of the good news has already been priced in. The bank cut its overweight stance on global equities and high-yield credit to underweight last week.

“There is an increasingly dangerous mix of stretched investor sentiment and positioning as well as stretched central bank rate pricing,” Kettner said. “From here we would need yields to fall even more to bring interest-rate volatility down more.” BLOOMBERG