Rupture in correlation between bonds and stocks not a problem, says analyst

Noting Thursday’s somewhat meagre gains, given U.S. data showing a strong economy but benign inflation, Mark Newton, head of technical strategy at Fundstrat, reckons: “The U.S. equity rally appears to be getting a bit tired.”

Perhaps any cooling of the bulls’ ardor reflects the market starting to pay more attention to shifting prospects for Federal Reserve interest rate cuts in the near future. The chart below from BTIG’s chief market technician Jonathan Krinsky, shows how stocks in recent months have closely tracked the odds of borrowing costs being trimmed in March.

But in the last few weeks the link has fractured, with stocks trundling higher as the chances of a 25 basis point cut in the Fed-funds rate have fallen from around 90% to less than 50%. “[T]his divergence is likely to resolve with
SPX
[the S&P 500] moving lower over the near term,” Krinsky warned in a recent note.

This just goes to show that market correlations can matter — until they suddenly don’t. The trick for investors is to understand whether the dislocation is only a brief aberrance or evidence of a fundamental shift.

Take the the 2-year Treasury, which Nicholas Colas, co-founder of DataTrek Research thinks “is the most important security in the world, at least when it comes to the direction of the S&P 500.”

Colas provides the following chart to show how 2-year yields moved since the start of 2022, and how the S&P 500 performed over those periods of rising, stable, or declining rates.

The relationship is clear, says Colas: “When 2-year yields are rising, stocks drop (all of 2022, August – October 2023). When they are relatively stable (January – July 2023, even with the sudden drop due to the U.S. bank mini-crisis) or declining (November 2023 – present), stocks go up.”

Importantly, Colas stresses, this is not mere correlation but causation, and explains what is going on.

Two-year yields reflect the market’s best guess about the Fed-funds rate over the next 24 months, he says, and in the context of the last few years of monetary policy it shows how investors have been trying to predict where short-term rates need to go to bring inflation back down to the Fed’s target of 2%.

This impacts stocks because when yields move higher the market frets that terminal policy rates will be far higher still than current levels. “This raises the specter of recession, since the U.S. economy can only withstand a certain level of interest rates before it buckles under the strain. No one knows where that level is, so any marked increase in yields is unwelcome,” he says.

Crucially, the 5% level on 2-year yields is what Colas calls a “break point for equity investor psychology”. Last year’s market pullback between August and October occurred as yields rose above 5% and looked liked going higher still, while the latest fall in yields eased those concerns.

But there’s a quirk. This year short-term rates have gone up but so has the equity market. Two-years began 2024 at 4.25% and hit 4.4% midweek, while the S&P 500 is up 2.6% year to date.

Colas has three explanations for the correlation rupture. First, stocks have tended to advance when yields are relatively stable, and frankly the latest move higher in rates is not that great relative to recent bond market volatility.

Second, “The FOMC’s December Summary of Economic Projections called for three rate cuts this year. Markets have assumed, rightly or wrongly, that the committee is being conservative. Either way, projected rate cuts put a ceiling on 2-year yields,” says Colas.

Finally, investors are relaxed about Fed’s policy trajectory. A recent survey by DataTrek showed only 6 percent of respondents said they expected no rate cuts or higher rates this cycle.

That’s not to say 2-year yields will stop exerting influence on equities, says Colas. After all there is still some uncertainty about about when the Fed will ease monetary policy and it likely will be better for stocks if bonds indicate the pivot is coming sooner rather than later and that a multi-year easing cycle is on the cards.

The takeaway from all this is that Colas thinks 2-year Treasury yields will likely determine if the S&P 500 has a good year, with a gain of between 5-10%, or an even better one well into double digits. “We think the latter is more likely, but lower 2-year rates would increase our confidence in that prediction.”

Markets

U.S. stock-index futures
ES00,
-0.15%

YM00,
-0.14%

NQ00,
-0.56%
were lower early Friday as benchmark Treasury yields
BX:TMUBMUSD10Y
dipped fractionally. The dollar
DXY
was little changed, while oil prices
CL.1,
-0.79%
fell and gold
GC00,
+0.26%
traded around $2,022 an ounce.

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The buzz

The December personal consumption expenditure price index will be published at 8:30 a.m. Eastern. Economists see the core PCE index, which is the Fed’s favored inflation gauge, increasing by 3% year-over-year, down from 3.2% in November.

Other U.S. economic data due on Friday, includes the December pending home sales report at 10 a.m.

Companies reporting before the opening bell on Friday include American Express
AXP,
+1.21%,
Booz Allen Hamilton
BAH,
-0.21%
and Colgate-Palmolive
CL,
+1.42%.

Lay-offs are picking up. Levi Strauss
LEVI,
+0.19%
says it will cut 15% of its corporate workforce, while Salesforce
CRM,
+0.78%
is planning to shed 700 employees, according to a report.

LVMH shares
MC,
+11.47%
are up 11%, pulling peers such as Kering
KER,
+4.70%,
Hermes
RMS,
+3.59%
and L’Oreal
OR,
+2.05%
up in their wake, after the luxury goods group reported higher-than-expected sales for 2023.

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The chart

Equity markets trading at new highs may suggest investors are relaxed, goes the thinking. That’s why, even though it might make sense to pay up for option protection when one’s portfolio surges, fewer do and the CBOE VIX index tends to move lower when stocks rally.

Indeed, extrapolating this reasoning, Societe Generale asks: “Don’t equity markets always make new highs when volatility is low?” They point to the chart below of the VIX when the S&P 500 hits a new record and answer: “Well clearly not.”

Top tickers

Here were the most active stock-market tickers on MarketWatch as of 6 a.m. Eastern.

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