The Market: Credit Calling UST's Bluff

On watch for a relatively hawkish June 12 event day to catalyze a retest of the May 31 SPY low circa $518 via higher long-term UST rates.

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Discussion

Patience pays in every way, shape, and form in markets. If something doesn’t make sense in the moment - wait. If a trade isn’t working out in a particular moment - don’t stop out…wait. (99.9% of the time the market provides an exit ramp to a bad trade/thesis.)

On Tuesday I wrote about the short-term change in character in SPX behavior, as indicated by the fact rates and stocks were down in tandem in a more classic risk-off manner. My supposition was equities were beginning to respond to the economic growth weakness indicated by the more cyclical parts of the equity market. But later in the day we got the real answer: Israel-Iran.

Now, the fall in rates is not all Israel-Iran. Cyclicals don’t breakdown in such a widespread manner without at least some softening in economic growth; and the price of oil is a tangential driver of long-term UST rates. But growth isn’t slowing enough yet to exert this level of downward force, and oil is overhyped as a rates driver.

The Transports vs. Utilities SPX sector pair has come in aggressively, foreshadowing the widely followed drop in the FRB Atlanta GDP nowcast this week…

…But this is likely at worst a deceleration inside of an on-going economic expansion, as indicated by both the lack of downside confirmation from the Discretionary vs. Staples pair and its recent upturn back above key moving averages.

And without getting distracted by the correlation “trees”, the “forest” of the Crude vs. Real Rate relationship - observable by eyeballing the chart of the last three years - shows that rates respond at the margin to upturns/downturns in the price of crude oil, but by no means does the level of crude determine the level of rates.

So, in my opinion the fall in rates was principally due to the risk-off threat from an escalation in the Israel-Iran conflict at the Lebanese border…and perhaps exacerbated by broad excitement about FED rate cuts in the wake of the Bank of Canada and the ECB cutting rates this week.

The Fed is Likely Unhappy

Of course, the Fed will be pleased with the constellation of data this week: job openings fell, ISM prices paid came in below expectations for manufacturing and services, and unit labor costs came in well below estimates.

But they will not be so pleased that they’re ok with letting stocks and bonds continue to rip from here on slam dunk guidance for a September rate cut, as currently indicated by the OIS market.

They are managing this economy on a string - quite literally day-trading the economy, if you follow their rhetoric closely. So, while they do not want the economy to go off a cliff, equally if not more so they do not want another round of reacceleration as a result of rapidly loosening financial conditions, ala 1Q24. They worked very hard in response to the Q1 reacceleration to get the long end of the UST curve back above 200 bps, and with this recent fall in rates TIPS 10s and 30s are right back to 200.

With equities trading at fresh ATHs, they have all the cover in the world to move rates back up via next week’s FOMC/SEP/presser…likely, in my opinion, by floating the possibility of no cuts until early 2025, in line with Waller’s comments two weeks ago.

Credit Calling UST’s Bluff

Very long story short: All that to say, the IG CDX market is calling the UST market’s bluff here, trading above the level it traded last time TIPS 30s were down here…and that’s despite equities at ATHs. If anything, IG CDX should be lower simply due to its correlation with equity indices.

I believe the IG CDX market is positioning for a move back up in rates in response to some combination of NFP Friday and CPI/FOMC/SEP/Powell next Wednesday. And given how wonky equity/VOL price action has been on these various market squiggles this year, it doesn’t surprise me SPX and VOL are taking their time to respond to the pretty decisive divergence in IG CDX vs. rates/stocks.

Tactical Risk & Portfolio Management

Despite the breakout in stocks, I continue to maintain the view outlined on June 3 that tactically it is unsafe to chase equities ahead of June 12, and recent IG CDX behavior solidifies that view. I think choppy SPX behavior will continue through June 12, and perhaps a bit beyond before equities take off for good in a gappy, lockout rally ahead of Election Day - similar to the May-June 2023 price action. The SPY 20dma circa $528 is of interest, but the 50dma circa $518 is of particular interest for two reasons: 1) the 50dma contained the choppy price action in May 2023, and 2) $518 would represent a nice retest of the May 31 low. Yes, it’s tough to think in “pullbacks” after such a powerful rally, but the Fed and rates are the key variables here that need to be considered when getting bullish of breakouts, as discussed above.

I continue to sit in the overweight equity position established on May 30, and if and when SPY pulls back to $518 I would not hesitate to increase that OW to a maximum position.

In my FICC strategy, yesterday I increased my UST 20s short position while leaving room for one more add if rates decide to move even lower. Doubt they do given IG CDX behavior, but I want some room.