What gives? Fed stays hawkish but bond yields fall, equities rise
Wow, what a month! Equities go from extremely bearish to up 9% for the month, while bond yields fall. Given the divergence views between bonds and equities, something has to give.
The Fed remained hawkish during the July meeting, but traders were having none of it, despite continued multi-decade highs in inflation. Yields on the US Treasury 10 Year fell 36 basis points during July as investors begin to price in an economic slowdown. Recall that the 10 Year was nearly 3.5% a month and a half ago. Bond managers have switched from inflation fear to recession fear.
This is best evidenced by the 2 Year – 10 Year yield curve which has now been inverted (short-term yields higher than long-term yields) for a month, typically a recession signal.
But while the bond market begins to price in a recession, equities rallied 9.1% in July! There are a number of reasons for this.
First, equity investor sentiment was so bad that it could not go any lower (Exhibit 4). In fact, institutional investors were taking less risk than during October of 2008 during the Great Financial Crisis! Basically, there were no sellers left. Investors were braced for bad news from the Fed and corporate earnings, both of which largely delivered. But the news was not worse than expected, providing the opportunity for a relief rally.
Second, too many investors were short of the market (and may still be). As seen in Exhibit 5, net CFTC futures (a measure of net bets for and against the direction of the S&P 500) were back to the levels seen during the early days of the pandemic crisis. With all these investors short, once the market turned around many are forced to buy (to cover their short).
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