Wednesday's Market Minute: The Pain Trade

My old boss and Chicago trading legend JJ Kinahan used to open TD Market drives with one of his favorite go-to trading jokes: “The market has one job: to screw each and every one of us every single day.” Always gets a good laugh, ‘cause it sure as hell seems true. 

The “pain trade,” as many call it: what could markets do that would inflict the most pain for the most investors? Right now, I think it’s pretty simple: a slowdown in the economy that causes corporate earnings to deteriorate for a prolonged period of time. Call me Captain Obvious, OK. But actually, I don’t think it’s all that obvious; it would probably require a dramatic debunking of one of the market’s most powerful narratives.

For years, traders have assumed that lower Treasury bond yields mean higher stock prices, and vice versa. It doesn’t have to be that way, and isn’t the case historically, but it’s been working pretty well lately. In the past eight months, bonds finally started selling off too hard, too fast, and we got a real bear market. And now, in the past month, we’ve gotten the first decent bear market rally as yields have fallen. Heading into the Federal Reserve’s meeting today, bulls are spinning the narrative that a slowdown in the economy will force Powell & Co. to dial down the hawkishness, which should keep yields contained and allow stock valuations to reflate. Getting the first part (yields down), but not the second (stocks up), would be the pain trade.

Inflation is still far above the Fed’s tolerance levels. We shouldn’t expect them to back down. A scenario in which the economy is indeed ailing enough to warrant a pivot from the Fed is the worst-case situation and would probably be the setup for a brutal new leg of the bear market. 

We may be seeing the yield-stocks narrative breaking down already due to the onset of a recession. Bonds have been rallying since some very weak economic data in the form of jobless claims and manufacturing PMI last week, but stocks are back under pressure anyway. If the 10-year yield drops below 2.7%, it would mark the end of this year’s uptrend in yields. It’s not something anyone should root for when the 10-year/3-month yield curve is in total freefall.

At this point, higher yields should be welcomed by investors, at least in the intermediate term. But old habits die hard, and a lot of investors will likely be screwed if bonds rally after a cautious Fed but stocks sell off anyway.

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