This week is full of economic data, central bank speeches as well as a tense time in the negotiations to end the war between Russia and Ukraine. Economic and event risk is high and intraday price swings are defining financial markets right now. What is interesting is that the big moves and news is not in equities, instead the action is in the commodity markets, the bond market and the FX market. For any followers of John Murphy’s Technical Analysis, this is exactly how his theory teaches us that markets work: equity moves follow on from these other asset classes, with bond and commodity markets being the most important. Thus, even if you do trade equities, there is not much point looking at them for long term direction right now.

Chart 1: US yields and equities

This chart highlights the contrasting fortunes of the bond market, in this case the short end of the curve (2-year and below Treasury prices) with the S&P 500 and the Russell 2000. What is most striking is the sharp outperformance of US stocks vs. the Treasury market since the last Fed meeting when Jerome Powell and co. sent a decisively hawkish message to the market that the Fed is out to fight inflation. After that meeting the debate was over: The Fed was focussing on inflation regardless of the war in Ukraine.

This chart suggests that equities don’t seem to be too bothered by this sharp fall in Treasury prices/ surge in Treasury yields, however, we think that two points are worth making at this stage. Firstly, the S&P 500 is outperforming Treasuries by a larger margin than the smaller, domestically focussed Russell 2000. This suggests that the larger, global companies, including some of the tech companies, are acting as a hedge against rising US yields at this point in the economic cycle. It also suggests that the market is marginally more concerned about rising interest rates and the impact on second tier companies in the US. If economic data starts to turn then we could see the Russell lag the S&P 500 even more than it is now and it may start to turn lower. This is why we are watching US economic data closely right now, including this week’s data dump of NFPs and PMI data that we will write about in more detail later this week. Secondly, this chart reminds us that recessions usually follow a tightening cycle, they don’t usually happen simultaneously. Inflation is nearly 8% in the US because the economy is strong, and this is reflected in the performance of the US stock market. When rate hikes eventually cool the economy, like they usually do (bar the mid-90’s Fed tightening cycle ) then this is when recessions start to bite, and stocks start to falter. Beware, if the Fed is to hike by 8-9 times in the next 12 months, as economists at Citi Bank now predict, then the recession for the US could be horrible and there could be a bloodbath on Wall Street and Silicon Valley.

Chart 2: What recession risk?

The yield curve is talked about frequently these days, and the one that has the highest positive correlation to the chance of recession in the US economy is the 10-year minus the 3-month Treasury Bill yield. This has the best hit rate for telling us that a recession is coming. As you can see, this yield curve is steep and continues to rise, and the differential is a massive 1.87%, although it did fall from 1.93% on Friday. It suggests a healthy economy at this stage. This is why US stocks are doing well and also why the dollar is surging. For now, the dollar is rising on a broad basis on the back of aggressive Fed rate hike expectations that, so far, don’t contain a recession risk, according to this important chart. After a few months of consecutive rate hikes from the Fed, and if US economic data starts to miss expectations and turn lower, then we could see this yield curve invert. When that happens, it is bad news for the US economy and for US and global stocks. For now, this is why the dollar index is once again close to 100.00. It is also part of the reason why USD/JPY briefly touched 125 yen earlier on Monday, after the BOJ said that it would embark on unlimited bond purchases to being down Japanese yields. This dragged the yen lower; USD/JPY is at its highest level since 2016, however, at these extreme highs it remains vulnerable to sharp sell offs and official Japanese intervention. USD/JPY briefly jumped above 125Y earlier on Monday, however, it finished the US session at 123.79Y.

Source: St Louis Fed

Chart 3: Well, why not

This chart shows the 10-year minus 2-year Treasury yield curve. It is considered the benchmark yield curve, but it isn’t as good as the chart above at forecasting recessions, and it doesn’t tell us anything we don’t already know. However, it is popular, and the market could freak out if it inverts in the near term. The yield differential between 2s/10s is currently only 11 basis points, it had been 18 on Friday, which is an example of the intense volatility in the bond market at the start of a new week. If this curve inverts, potentially on the back of stronger than expected US Non-Farm Payrolls for Friday, or strong PMI reports that suggest the US economy is coping well with high inflation and the uncertainty caused by the war in Ukraine, then the market is likely to freak out. It will be worth watching to see if stocks can post gains when the 2/10-year yield actually inverts. If this happens, then the Fed may have to embark on an even more aggressive rate hiking cycle to bring inflation under control.

Source: St Louis Fed

This week it’s all to play for, and it’s only the start of a crucial week for markets.

3 charts to watch closely as bond markets burn