Bonds’ Silver Lining
Assumptions were made to be broken. An oil price spike automatically raises prices, so it’s bad for inflation. That generally causes bond yields to rise, as the assumption is that central banks will have to raise rates to combat the higher prices. But it also acts like a tax hike, forcing consumers and companies to spend less on things other than oil. All else equal, that justifies a rate cut, and lower yields.
Further, the logic of bonds is that they act as a shelter in times of stress — which means investors buy them during extreme uncertainty and conflict, like the past month. Thus it’s always been strange that the bond market unambiguously reacted to the Iran war’s inflation risk, but not to the threat to growth, and sent yields higher. Until now. Both yields and rate expectations for the Federal Reserve suddenly dipped Monday:
On Second Thoughts...
Bond markets are shifting on the risk that slow growth could force rate cuts
It’s not obvious why this happened when it did. Traders entered the crisis with leveraged positions, meaning that some of the rise in yields since then has come through a classic trading squeeze. Also, comments by Fed Chair Jerome Powell in the US morning helped further dispel the notion that rate hikes were a certainty. The immediate effect was to spark a sudden recovery in equities despite another dispiriting weekend of news from the Gulf. To quote one macro strategist:
Interesting. Equities trading much better because Fixed Income is trading much better. Fixed Income is trading much better because we suddenly chose to fear growth more than Warflation.
The classic measure of a growth scare is to track the performance of stocks relative to bonds. On that basis, although nothing like last year’s Liberation Day selloff, the fall in stocks has now brought them back to their level of inauguration week in January 2025. Since then, stocks and long bonds have exactly matched each other:
Back to Inauguration Week
Stocks have surrendered all their gains over bonds since Jan. 23 last year
The bond market did allow a nice lift for stocks at the US opening, but it didn’t last. Even when handed an excuse for a rally, equities didn’t take it. That was mainly because of the oil price, with West Texas Intermediate, the main US benchmark, closing above $100 for the first time since the attacks on Iran began. (It fell later after the Wall Street Journal reported that Trump was considering ending the war without reopening the Strait).
Oil Spoils the Party
After a strong open, stocks took a cue from rising crude prices - and fell
As Points of Return has covered, the markets remain on alert for a relief rally, and this is deterring many from selling. Measures that normally gauge extremes of risk appetite suggest that people are now negative enough for a rally to start — but the problem is that this selloff isn’t a question of risk appetite. To quote Harry Colvin of Longview Economics:
Equities are in an environment when you have all these technical and sentiment risk appetite models that really suggest you should get involved and buy again. But markets aren’t really driven by risk appetite so much as news flow. If it does rally it’s probably an opportunity to unload more risk, absent some sort of resolution of this conflict.
Put differently, stocks are almost in the textbook world where they follow a “random walk” incorporating all news as soon as it is known. Usually, waves of sentiment ensure that moves aren’t truly random. But now, we need to keep watching the news and be prepared to react. It’s the uncomfortable reality of the moment.
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