Unprecedented in 23 years! More and more stocks are "bound" to U.S. Treasury yields.

Finance Associated Press, January 12 (Editor Xiaoxiang) Behind the resumption of the upward trend of U.S. stocks in the past week, there is an increasingly prominent signal that is making some industry insiders anxious - that is, the increasingly closely correlated between U.S. stocks and U.S. Treasury yields more or less means that if U.S. inflation cannot be reduced quickly, traders may be in big trouble.

According to Société Générale, two-thirds of the S&P 500's market capitalization is now "tied to" the trend of Treasury yields – performing better when interest rates fall and vice versa, the highest since 2001.

A similar phenomenon is becoming more prevalent in the MSCI World Index......

While U.S. equities have had a volatile start to 2024, many investors are still firm in their bullish beliefs since last year, which pushed the S&P 500 back to its rally last week – up 1.8% for the week. However, last week's mixed picture of oil markets and consumer price indicators raises an obvious question: Are bond yields friend or foe for traders who believe that the direction of interest rates will guide markets?

The core issue of the U.S. stock market is actually valuation. But the sharp inflation in market valuations over the last year has made it particularly vulnerable to unforeseen outcomes in the Fed's policy path – if lingering inflationary pressures prevent Fed Chair Jerome Powell from easing policy aggressively in the coming months, there will be little room for error among Wall Street bulls who drove a sharp rally in equities at the end of 2023.

Andrew Lapthorne, head of quantitative research at SocGen, noted that if bond yields do not fall, a large proportion of stocks in the market will face significant valuation pressure. We have a lot of stocks that are overvalued in market capitalization and have a positive correlation with bonds.

It is worth noting that last week, a number of Fed officials once again poured cold water on the market's expectations of aggressive interest rate cuts this year. Cleveland Fed President Mester said it was too early to consider cutting interest rates at the Fed's March meeting. The Fed member of the annual voting committee noted that the new inflation data showed that Fed policymakers have more work to do.

Looking at the pricing in the interest rate swap market, traders now expect the Fed to cut rates by 150 basis points this year – about six 25 basis point cuts, which is a full double the Fed's December dot plot projections. At the same time, the industry's estimate of the probability of the Fed cutting interest rates in March has also risen to more than 80%.

As traders rush to risky stocks, bonds and credit, any hawkish warnings now sound more and more counter-resounding, but their potential impact and danger are growing by the day.

Danger looms

All of this is a warning that when investors invest in small-cap stocks and junk bonds, they may end up disappointed with the lower-than-expected actual rate cuts and corporate profits. And now is the disclosure period of the earnings season for US companies.

In 2023, large-cap tech stocks, represented by the Big Seven, led the double-digit share price gains, which means that the growing weight of the S&P 500 is closely tied to the long-term earnings outlook – and therefore more sensitive to a return to yields. After the rise in stocks and bonds in the last quarter, the start of this year has actually been quite bumpy. Even if the S&P 500 jumped last week, it has been flat so far this year.

Judging from the trend of inflation in the United States, Fed officials are still facing the risk of repeated inflation. While Friday's data showed a surprise drop in PPI, the more closely watched CPI data came in higher than market expectations. The situation in the Red Sea and rising shipping costs have also exacerbated some investors' concerns about a resurgence in inflationary pressures.

Last Thursday's CPI report showed that while inflation has generally eased, the pace of the pullback is slowing, Michael Purves, founder of Tallbacken Capital Advisors, wrote in a note. The threshold for a rate cut is much higher than the one that emerged after the December FOMC meeting.

The positive correlation between equities and bonds has also risen further as inflation concerns linger – the 60-day positive correlation between the S&P 500 and the benchmark Treasury continues to widen, and this correlation has been threatening the hedging role of bonds since last August.

For Marija Veitmane, senior multi-asset strategist at State Street Global Markets, this leaves the stock market with little reason to rally further in the medium term. Veitmane believes that the December 2023 rally in U.S. equities was actually borrowed from this year. Strong data can make markets panic into thinking that a rate cut is not coming, while too weak data can raise fears of a recession. "

In addition, according to Max Kettner, chief multi-asset strategist at HSBC Holdings, most of the positive news has also been priced in. The bank last week downgraded its rating on global equities and high-yield credit to underweight from overweight.

"Investor sentiment and positioning are extremely tight, and central bank interest rates are also extremely tight, which is an increasingly dangerous combination," Kettner said. From now on, we need yields to fall further to further reduce interest rate volatility. ”

(Finance Associated Press Xiaoxiang)