The Ongoing Tug of War, Potential Danger Ahead

The first week of March has been filled with the same “tug of war” action that typified the months of January and February, which I began discussing in my first Whispers of 2023.  The two-day short squeeze rally following non-voting Atlanta Fed President Bostic’s comments last Thursday has reversed quite violently this week on Chair Powell’s two-day testimony in front of Congress, as well as the job data that is not showing clear signs of deterioration.  When I take a step back from this headline noise, my work suggests two things that are quite clear to me — the data is not supportive of dovish Fed hopes, and the equity market is still in a state of denial with the S&P 500 remaining near 4000. 

To quickly show support for my view, let’s look at a few simple charts below.  The bond market’s volatility expectations metric, called the MOVE index, has been noticeably rising since early February, while equity volatility as shown by the VIX has been FALLING.  This positive inflection in bond volatility began in earnest with the reemergence of a potential 50bps Fed hike by Fed speakers Mester and Bullard, which I had flagged on 2/15 as a rising possibility BEFORE it occurred.  During this roughly one-month period, Fed expectations have gone from a June pause (terminal rate under 4.9%) and 70bps of easing by January 2024 to 5.70% terminal rate and only a small easing by January next year, which still looks to be too dovish.  In my mind, that is a dramatic reversal, and it appears to be reflected in investors' bond-volatility expectations to some degree.  Importantly, however, the expected volatility for equities is still near the lowest levels in over 10 months.  Yes, there could be lots of reasons why this is happening, but it does seem to suggest that the equity market has not fully priced in the new reality, which may even get worse over time.  Based on my key indicators, it is just a matter of time before things come back into alignment and the equity market properly adjusts to my longstanding view of the Fed is higher for longer.  Hence, the remainder of 1H23 will likely be a challenging period for equity investors. 

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