Is equity market ignoring signals from bond market?

By Steve Sosnick

Going forward, US equity markets need to resolve a few key elements before we can label this move a stable advance, let alone a new bull market.

Are we continuing to fight the Fed, and for how long? Bond traders, particularly those at the short end of the curve, took immediate notice to the idea that they hoped for reduction in peak rates is less likely now than it was a week ago. They also began to price in a smaller probability for rate cuts in the 2nd half of the year.

Bonds and the dollar reversed the moves that they made in the day and a half between Powell’s post-FOMC press conference and the payrolls report.

Stocks didn’t. Between rates and quantitative tightening, it is quite clear that the monetary tide continues to recede. It is odd that stock markets seem to be ignoring that fact.

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Are we going to get the hoped-for soft landing? That seems to be the base case for equity markets, yet true “soft landings” are a historical anomaly. Could the Fed engineer one? Sure. Should that be investors’ base case. Not so sure.

Under what circumstances might we get the rate cuts that are being priced into Fed Funds futures? There is virtually no historical precedent for the Fed to finish an aggressive rate hike cycle, then turn around within 3-6 months to cut rates. It seems illogical that they would declare victory over inflation and then immediately reverse course. This idea has been echoed numerous times by Fed talking heads. The only plausible reason for such a reversal would be if a recession forced the central bank’s hand. We should be careful what we wish for.

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How has the plethora of short-term options affected the recent market action? Late last year, we saw exchanges list so-called “zero-dated” or “0DTE” options listed in a range of key indices and ETFs.

They have proven immensely popular, with cumulative options volume setting a record last Thursday (the day after the FOMC meeting). For better or worse, they have made speculation incredibly easy. It is likely that these products exacerbated December’s decline, and it is almost certain that they have accelerated this year’s rally.

Most traders are more comfortable trading from the long side rather than the short side, which explains the recent pops in volume on up days. Over time, the effect will fade. Markets learn to adapt to new financial innovations and speculators can be fickle. But in the short-term, it would not be surprising if these ultra-short-term options lead to microbursts of volatility and the occasional spurious move.

Higher for Longer? — It’s taking markets a little bit of time to fully digest the ramifications of last Friday’s payrolls report. Short-term interest rates and the dollar are continuing their rapid advances today, but it appears that equity traders are torn between nervousness and the recent rekindling of their love affair with buying dips.

We have often asserted that “if safe assets are getting clobbered, risk assets don’t stand a chance.” This was a key explanation for the lousy performance of equities and riskier assets during 2022. Risk-free rates are a key component of nearly every asset pricing model. If they rise sharply, that should negatively impact the value of the riskier asset that is being valued.

But we also know that while equity prices should be negatively impacted by higher short-term rates, do we really think that traders of ES and NQ futures, let alone those trading zero-dated options or low-quality, high-beta stocks are modifying their momentum-based strategies to reflect perceived changes in discounted cash flows or dividend discount models? Of course not.

That is why equities can make extended moves that seem to fly in the face of broader macroeconomic trends. Disinflation can indeed be a positive factor behind equity prices, but higher rates are not, nor is a stronger dollar a positive for earnings at the multinationals that dominate key US index weightings. Eventually, fundamentals take hold. Eventually, equity investors will need to decide if they actually want a rate cut if that implies a recession. But for now, momentum seems to be the deciding factor, even as higher rates are once again a key backdrop.

(Author is Interactive Brokers’ Chief Strategist)