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Stocks rallied on Wednesday as US Treasury yields backed off recent highs — a brief respite from the blistering pace of higher rates that began with the third quarter.
Over the last three months, longer-term yields have been screaming higher while short-term rates have risen only modestly. In what’s known as a bear steepener, the moves are making the highly inverted US Treasury yield curve a bit less inverted.
Some investors might cheer the movement toward a more normal bond market, where long-term yields are higher than short-term rates. But the breakneck pace of the rates rally combined with slowing economic growth is flashing a giant warning to bond market observers — with echoes of prior financial panics.
Alfonso Peccatiello, founder and CEO of The Macro Compass, recently joined Yahoo Finance Live to break down the market moves and add historical context.
“I think the bond market is now testing the hypothesis that the economy can handle higher interest rates,” said Peccatiello, commenting on the market’s resolve to test the Federal Reserve’s “higher for longer” mantra.
He compared the present economic environment to that of the Global Financial Crisis and also late-2018, the last Fed hiking cycle that ended before the pandemic.
“When long-end rates go higher while nominal growth is [slowing] late in the cycle, it’s a very dangerous cocktail for risk assets,” he said.
Peccatiello explained that the recent bear steepener in the bond market is common at this late stage in the business cycle, when the Fed has hiked significantly and is beginning to lift its foot off the brakes.
The problem comes when the big move higher in rates occurs with slowing economic growth, which is the lagged effect of the Fed’s rate hiking.
Peccatiello said these bear steepening cycles typically last six to 10 weeks and that the current episode is already in its 10th week.
“It generally takes a few months until risk assets really crack badly,” he said.
Exactly how that plays out is highly contextual and difficult to pinpoint. But Peccatiello pointed to 2018 — when the credit markets froze — as one possibility, with the potential for outright disaster — á la Global Financial Crisis — at the far end of the spectrum.
Back in 2008 and 2018, the Fed rescued the markets by easing financial conditions. But today, the Fed’s hands are largely tied, as inflation remains well above the Fed’s 2% target.
For the time being, Peccatiello is warning investors to steer clear of risk assets like stocks until there is capitulation in the stock market, credit markets, or both.
“At some point, the pain is going to become acute,” he says, adding that once capitulation occurs, investors can start wading into bond markets again. And when the Fed finally cuts rates, bonds should be the big winner.
Friday’s monthly jobs report from the Bureau of Labor could be a catalyzing event after Wednesday’s employment report from ADP materially missed expectations.
If the data comes in hot, Peccatiello said, investors would likely chase yields higher until they finally become a chokepoint in the markets. A 5% yield really “starts to become a real burden for risk assets,” said Peccatiello.
On the other hand, if the headline payroll number comes in weak (much less negative), the weakening labor market could signal a recession is near, which would also send stocks and rates down.
Peccatiello acknowledged the irony of the situation, saying: “Too hot a number [or] too cold a number — it’s bad for stocks.”
A “just right” Goldilocks report merely kicks the can to the next potential catalyst.
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