Stock-market bravado tested as bonds flash Fed policy danger

Bloomberg

The fastest inflation print in nearly 40 years is rattling nerves on Wall Street where economically sensitive trades are hitched to an ultra-accommodative Federal Reserve.
The spread between five- and 30-year Treasury yields has narrowed relentlessly this quarter, with that curve now near the flattest since March 2020. It’s a sign bond traders are betting faster rate hikes will undercut the red-hot economic expansion, possibly disrupting the business cycle in the name of
inflation-fighting credibility.
A slew of stock market corners beneath a heady S&P 500 are channeling bond-market angst, with stimulus fading, still-clunky supply chains and a new coronavirus variant spreading.
Yet it’s far from clear-cut. Many say the bond warning is a head fake with plenty of juice left in stock trades hitched to robust recovery.
“It’s the expectation that short-term rates are going to increase and a risk that by moving too aggressively the Federal Reserve and other central banks could choke off the recovery,” said Brian O’Reilly, head of market strategy at Mediolanum International Funds. “That’s what the bond market is saying. I don’t necessarily agree.”
He still recommends a modest tilt toward beaten-down value shares given their sharp discounts to the rest of the market, even as the bond market’s alarm signal over economic growth jars assumptions behind popular reflation trades.
Caution has crept back into cross-asset markets this quarter as the Fed sends its clearest signal yet it will hasten monetary tightening. In the wake of the hawkish turn, swaps are pricing in close to three quarter-point rate hikes in 2022.
The Bloomberg Dollar Spot Index is up for a second straight quarter and emerging-market stocks plunged to the lowest level versus their developed peers in 17 years.
US small-caps are set for the worst quarter versus large-caps since the first three months of 2020. A defensive play that goes long profitable shares and short the opposite is similarly poised for its best quarter since early pandemic days.
Hand-wringing over the yield curve has been a familiar feature of post-crisis markets — and it’s stirring up much contention again this time around. The head of global bonds at Janus Henderson said this week the flattening is near an end. 22V Research says yield-curve relief is coming once Covid fears fade and cyclicals are still the way to go.
By their calculations, the recent collapse in the two- and 10-year spread relative to its 200-day average stands at the 100th percentile historically, meaning it’s almost never moved as quickly.