It’s summertime, but the living may not be easy, at least for the financial markets.
The summer solstice arrives in the Northern Hemisphere on Sunday at 11:31 p.m. Eastern Time, and the main priority for everybody cooped up by Covid-19 is to get out and go somewhere, anywhere. In ages past, that typically meant that financial markets entered the doldrums, which sailors associate with the season. That’s been less and less the case in recent years, and this summer shapes up to be less than tranquil for the markets.
Credit or blame the Federal Reserve, which this past week signaled an eventual move away from its current ultra-easy monetary stance. While the Federal Open Market Committee made no current policy changes, its so-called dot plot of the members’ guesses about the future federal-funds rate target showed two one-quarter percentage point increases by the end of 2023. In its previous set of dots released at the March meeting, the median dot still had the Fed’s key policy rate at the present rock-bottom range of 0% to 0.25% more than two years hence. To be sure, Eurodollar futures contracts already had been pricing several rate hikes by then, so in essence the dots were getting marked to market.
More proximately, Fed Chairman Jerome Powell allowed that the monetary authorities had finally begun talking about talking about a reduction of its massive bond buying, consisting of $80 billion of Treasuries and $40 billion of agency mortgage-backed securities every month.
In other words, the Fed’s super-easy monetary policies—which were put in place in March 2020, during the worst of the economic and financial chaos brought about by the pandemic—will have an eventual expiration date. With the U.S. economy growing strongly and inflation running at multiyear highs, the time for these emergency policies would seem to be running out. Yet the admission of this seemingly self-evident fact took markets by surprise.
Recalling the “taper tantrum” thrown by the bond and stock markets in 2013, when the Fed last announced plans to curtail its bond-buying program, Powell made clear that the Fed would apprise the markets well in advance. Still, the introduction of this uncertainty means some increase is likely in the markets’ recent subdued volatility.
“With equity markets [at the index level] having been in a near-catatonic state, it’s inevitable that volatility should pick up,” Julian Emanuel, chief equity and derivatives strategist at BTIG, remarks in a phone interview. The Cboe Volatility Index, or VIX, has been mostly stuck in the teens, consistent with somnambulant stock trading, for around three months.
This coincides roughly with long Treasury yields topping out after their sharp first-quarter rise and gradually receding from a recent peak of 1.75% on the benchmark 10-year note to below the 1.50% mark. That was contrary to widespread predictions that longer-dated bond yields would continue their upward march to 2% on the 10-year Treasury.
And the Fed’s announcement that it had started talking about a reduction in bond buying, along with an eventual interest-rate hike, did spark an immediate uptick in bond yields. But then things got a little weird in rate markets on Thursday in the second-day reaction to the FOMC meeting.
Rates rose at the short end of the market while yields on more distant yield-curve maturities moved lower, resulting in an overall flattening of the slope, writes William Naphin, an interest-rate derivatives strategist at R.J. O’Brien, a Chicago institutional broker, in a client note.
In the Treasury market, the two-year note—the coupon maturity most sensitive to Fed rate expectation—moved up 0.226%, the highest since March 2020, from around the 0.15% level it’s been stuck at for over three months. At the long end, however, the 30-year bond yield slumped to 2.104%, its lowest level since Feb. 18.
Such a divergence has been rare in recent years. While money-market rates rose while Treasury yields fell 33 times since 1995, it’s been seen only once since 2011, he adds. Such episodes were fairly routine in the 2001-03 period, when the Fed was also in an emergency policy stance during the recovery from the recession that followed the bursting of the dot-com bubble.
Hedging of mortgage portfolios against rising rates (by taking offsetting positions in Treasuries or derivatives such as futures and options) had rippled through the markets then. That is less relevant now, but then there was no risk then of a Fed tapering. In any case, recalling that episode, Naphin concludes that he now wants to bet on higher, rather than lower, volatility.
For his part, Emanuel dismisses the bond move as the side effect of the plunge in commodities that followed the Fed news, calling it “a tail wagging the dog.” Owning commodities has been an extremely crowded trade, he adds, which was corroborated by Bank of America’s monthly survey of fund managers released earlier in the week.
Regardless of its basis, the configuration of a flatter yield curve, a decline in previously hot commodity prices such as copper, plus a stronger dollar that followed the FOMC announcements and Powell’s postmeeting comments to the press, all point in a disinflationary direction.
They also suggest further pickup in volatility with the likely increase in the volume of Fedspeak among various central bank governors and district presidents in coming weeks. First among them was the ever-loquacious St. Louis Fed head James Bullard, who on Friday suggested the first rate hike could come as soon as next year, making him one of the seven FOMC dots expecting liftoff in 2022.
The consensus seems to be that Powell will unveil the Fed’s plans to slow its securities purchases at the annual big policy confab in late August at Jackson Hole, Wyo. For his part, Emanuel thinks the FOMC should announce something at its next meeting July 27-28. “If not now, when?” he asks.
In particular, the calls for the Fed to slow or even end its monthly purchases of $40 billion of mortgage securities have become more widespread. On that score, Bullard appeared to be in agreement. “I’m leaning a little bit toward the idea that maybe we don’t need to be in mortgage-backed securities with a booming housing market,” he said. “I would be a little bit concerned about feeding into the housing froth that seems to be developing.”
Even without the central bank reining in its bond buying—which pushed its balance sheet past the $8 trillion mark as of Wednesday, nearly double its prepandemic size—Lori Calvasina, RBC’s head of U.S. equity strategy, thinks the decline in the 10-year Treasury yield during the second quarter may be signaling a slowing in the economy. That thesis was proposed in this space a week ago.
The slippage in long Treasury yields could portend a slump in the widely watched ISM gauges, which she says may be associated with either a pause in the leadership in cyclical stocks or a pullback in the overall market. In that case, she suggests adding to classic defensive groups such as consumer staples, utilities, and healthcare to ride out a short-term pullback. Financials, energy, and materials, which had been leading the market, still make sense longer-term, while industrials lack appeal because of valuation, she adds.
Emanuel also prefers exposure to defensive groups such as healthcare, but because he looks for bond yields to resume their ascent, with the 10-year Treasury heading toward 2%, which would pose a headwind for equities. At the same time, he’d steer away from transports and high-multiple secular growth stocks, which are sensitive to higher yields.
And he’d play a rise in volatilities with options. In a client note, he recommended a straddle, simultaneously buying July 30 calls and puts on the S&P 500, a position that would pay off from big moves higher or lower but would lose the cost of premiums paid on those options if the market stays rangebound. If July brings fireworks beyond the Fourth, however, the bet would be a winner.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
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