Bond Market Fluctuations and Economic Concerns
In recent days, the stock market has witnessed a reprieve in its upward trajectory as U.S. Treasury yields retreated from recent peaks. This respite follows a period of rapid rate increases that commenced in the third quarter.
Over the past three months, long-term yields have surged, contrasting with the modest uptick in short-term rates. This phenomenon, known as a bear steepener, has started to ease the inversion of the U.S. Treasury yield curve, where long-term yields become higher than short-term rates.
While some investors may view this shift as a step toward a more conventional bond market structure, where long-term yields outpace short-term rates, caution is warranted. The breakneck pace of the rate surge, coupled with signs of economic deceleration, is sounding a significant alarm for those monitoring the bond market—echoes of past financial crises resound.
Alfonso Peccatiello, founder and CEO of The Macro Compass, recently offered insights on these market dynamics and contextualized them within historical contexts during an appearance on Yahoo Finance Live.
Peccatiello remarked, “I believe the bond market is now testing the theory that the economy can withstand higher interest rates,” alluding to the market’s determination to challenge the Federal Reserve’s commitment to a “higher for longer” interest rate stance.
Drawing parallels to periods like the Global Financial Crisis and the late-2018 Fed tightening cycle that preceded the pandemic, Peccatiello expressed concerns about the current economic climate.
“When long-term rates rise while nominal growth decelerates late in the economic cycle, it presents a precarious situation for risk assets,” he cautioned.
Peccatiello elucidated that bear steepening phases in the bond market are typical during the latter stages of the business cycle, especially when the Fed has significantly raised rates and is starting to ease its monetary policy.
The real concern arises when the substantial rate increases coincide with a slowdown in economic growth, a phenomenon lagging behind the Fed’s rate hikes.
According to Peccatiello, these bear steepening cycles tend to persist for six to ten weeks, and the ongoing episode has already entered its tenth week.
“It generally takes several months before risk assets experience significant turbulence,” he explained.
The precise outcome of this scenario is context-dependent and challenging to predict. However, Peccatiello pointed to 2018, when credit markets froze, as a potential scenario, with the extreme end of the spectrum resembling the Global Financial Crisis.
Notably, in 2008 and 2018, the Fed intervened by easing financial conditions to stabilize the markets. Today, though, the Fed’s options are limited due to persistently high inflation exceeding its 2% target.
Peccatiello currently advises investors to exercise caution with risk assets like stocks until either the stock market or credit markets experience capitulation.
“At some point, the pain will intensify,” he warned, suggesting that once capitulation occurs, investors may cautiously reenter the bond markets. Bonds are expected to emerge as significant winners when the Fed ultimately lowers rates.
Jobs Report Impact on Market Dynamics
Friday’s impending monthly jobs report from the Bureau of Labor Statistics has the potential to serve as a pivotal event following Wednesday’s ADP employment report, which notably fell short of expectations.
Should the forthcoming data indicate robust job growth, Peccatiello anticipates investors will continue to pursue higher yields, possibly reaching a threshold where they burden risk assets. He pointed out that a 5% yield could pose substantial challenges for such assets.
Conversely, a weak or less negative payroll figure might signal a looming economic recession, prompting declines in both stocks and rates.
Peccatiello recognized the irony of the situation, concluding, “Whether the report is too favorable or too unfavorable — both scenarios could spell trouble for stocks.”