Market Thoughts: Get ready to rumble?

There was a widely circulated quote when the U.S. sent troops into Afghanistan, attributed to the Taliban. It went something to the effect of… ‘the U.S. may have all the watches; we have all the time.’ History occasionally repeats but always rhymes.

When government bond markets rumble, risk assets eventually respond. We’re seeing a bit of that currently. So far, they’re baby burps. Investors continue to see rising inflation and its pass-through effect, a shock to growth, building. Markets have taken note.

Bond markets are rarely wrong about the economy. Though I will say, they can exaggerate an occasional temper tantrum to make a point. Especially when bond vigilantes feel central banks are offside in policy action or risk assets need to be reminded of building tail risks that are being ignored.

I don’t believe central banks are offside in their policy positioning. But as inflation pressure builds—with the Strait still effectively closed as of this writing—they’re being dragged from dovish to hawkish. Risk assets are wobbly. So far, investors have steady hands.

As for dry powder, retail and institutional investors are already long risk assets. They’ve been adding to equity overweights based on the strength of earnings and margins. The S&P 500 looks to close out this earnings season with revenue and earnings per share growth rates of +11% and +28% year-over-year, respectively.

With regard to the Strait, the clock is ticking. From the myriad of policy and military experts I get to hear from, they each currently land in the camp of seeing no ‘obvious’ quick off-ramp to the stalemate. It’s in Iran’s interest to drag this out. It’s in U.S. interest not to escalate. And so it goes.

A re-escalation of war could quickly push long-term bond yields much higher. A run to—or through—5% on 10-year U.S. government bonds would send risk assets spiraling as investors sell overbought momentum and beta, along with rebuilding hedges. Momentum works in two directions.

A de-escalation that reopens the Strait would help bond and equity market jitters calm. As reports continue to swirl both about re- and de-escalation, keep a close eye on energy prices and a potential flattening of the futures curve. I’d say the same for the bond market.

The ‘best case’ for markets is for central banks to remain on hold. I think that’s what we get from the Federal Reserve (Fed) at the June 16-17th policy meeting. Futures markets indicate rising expectations for a rate hike later this year. June marks the first policy meeting Kevin Warsh will chair. Welcome and best of luck.

Warsh has signaled a dislike of the Fed’s forward guidance. It will make for quite a coming-out if he moves quickly to scale it back. I don’t know how markets would react. It’s clear, for now, central banks have their hands tied to a neutral or more hawkish policy stance.

Investors expect a ‘defensive’ hike from the European Central Bank (ECB) in June. Also, from the Bank of Japan (BoJ). Markets believe the Bank of England is likely to stay on hold. Between now and then will feel like a lifetime. Especially if the Strait stays closed.

A ‘smart’ central bank lets a market do the heavy lifting for it. That way, if they hike (or cut) policy rates, it’s more affirmation of market direction than ‘shock and awe.’ Markets are providing the ECB and BoJ an opportunity to raise rates in June. We’ll see.

Investors are hoping for another Fed policy pause in June. If supply chains remain disrupted, they recognize the direction of travel. It’s for interest rates to press higher. Equity investors are by nature optimists. Bond investors are pre-wired to be cautious. On a bad day, grumpy. Grumpiness unfortunately abounds.

Credit spreads are well-behaved, aligning with equity markets in their constructive outlook. That makes sense given where fundamentals stand today. With watches ticking, bond vigilantes will eventually demand reconciliation. Where bond markets lead, risk assets follow. Always.

Equity investors are paying attention to bond yields. Even more so if they gap higher. Reconciliation happens one of two ways… the easy way or hard. Get ready to rumble?

“I used to think that if there was reincarnation, I wanted to come back as the president, or the pope, or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” James Carville