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Last week was an incredible ride, with inflation data, sizable Treasury auctions, Fed minutes, a litany of speakers from central banks, big bank earnings, and of course the tragic events that continue to unfold in the Middle East. The markets struggled to maintain their gains, with the S&P 500 closely modestly higher on the week.
As I cautioned during the last Navigating the Markets, looks can be deceiving and the market can turn on a dime in both directions. Indeed it did and I believe we remain in a similar situation as we approach yet another week full of volatility catalysts.
Speaking of volatility, the VIX zoomed higher on Friday. I've been saying I thought volatility was mispriced for some time, meaning that I felt it was a bit too cheap.
I believe we're on the other side of that equation now, with volatility in US equities being more reasonably priced as we approach peak VIX seasonality and VIXperation.
Given the dynamics playing out with geopolitics, earnings season, and major economic data releases, however, I don't believe that it's the time to fade volatility either.
Instead, I would be more cautious of long volatility positioning. Especially given that one of the catalysts for Friday's move was Israel's announcement of a potential ground incursion into Gaza over the weekend, which international pressure seems to have temporarily deferred.
Should that threat play out, which is one that is continuing to be discussed with potential imminence, it could bring a bid back to bonds, the US dollar, oil, gold and volatility with equities potentially having more downward pressure.
The Big Picture
It's fair to say that we're experiencing one of the worst bond bear markets in US history, if not the very worst. Longer-term US government bonds are down over 50% now from peak to trough, which is an incredible loss and it illustrates the stunning magnitude of central bank intervention distorting credit markets for over a decade.
As that easing was reversed into aggressive tightening, we've seen an implosion in sovereign debt around the world, putting upward pressure on rates within the broader credit markets, particularly on longer duration debt.
We may not be out of the woods yet, either. While the 5s-to-30s spread is hitting positivity of late, the 2s-to-10s spread remains inverted by 44 bps. This suggests that the long-end of the yield curve still has some room to move higher as a part of a broader bear steepener.
Often is the case that when we do push into a steepening yield curve, we see recessionary pressure build. Indeed, as capital costs appreciate, this can drag the economy down. We can see many past episodes marked by that steepening, showing a recession playing out shortly thereafter. Usually within months of rising above a +50 bps spread between 2s-to-10s..
The re-acceleration of inflation is a theme I've been tracking for the past several months as we've seen increasing costs of energy, certain foods, key services, and signs that the base effects that helped to spark the 'immaculate disinflation' have all but run off.
Bank of America is looking for CPI to begin trending back up to 4-4.5% by next June. If that's the case, it further suggests that the Fed has more work to do. They don't necessarily have to keep hiking, but they are likely to keep rates high for a longer period of time than many expect.
This tightening has a big impact on businesses that need to borrow, refinance or are dealing with revolving credit lines. Small businesses often fall into one or more of these buckets, and as a result a reduction in the availability of credit combined with a rising cost of capital often leads to an increase within initial jobless claims. Particularly if we see JOLTS data show a reduction in job openings, such that it's harder to go from one job to the next.
Jobless claims reaching over 300K week-over-week combined with a contraction in ISM Services PMI data, where the economy as been most resilient, would be two areas to monitor closely for signs that the economy is starting to slow into a potential contraction.