Wednesday's Market Minute: Changing The Rules

Two reliable macroeconomic relationships have defined the bear market environment: bonds and stocks selling off together, and the U.S. dollar rising when stocks are down.

While there’s limited evidence of it so far, traders should be wary of a potential shift in those rules.

The relationships represent two sides of the same coin that is America’s leadership in the post-COVID recovery. America’s economy has been the most stable, earliest in its recovery, and now enjoys the unenviable luxury of having to meaningfully raise interest rates for the first time in about a generation. Since we invented vaccines, the spread between the 10-year and 90-day Treasury rate has been steadily trending higher. This bond sell-off is a good thing that represents our post-COVID recovery, but as of last November, has been problematic for the stock market as yields evidently overwhelmed the stock market’s tolerance for high valuations.

As a result, the general mindset by traders has been that higher yields are bad for stocks and lower yields are good for stocks. That was true in a low-inflation, low-growth environment in which a passive Fed was the best thing for the economy, but that could be changing. Recession indicators are rising and that uptrend in that yield curve is now under intense pressure. This is where traders should be very careful in assuming stocks and bonds will maintain their tight correlation, i.e., that yields going down is still a positive for stocks. If this yield curve continues to compress, it’s likely a sign that the economy is slowing down – not necessarily that the Fed is slowing down its hawkish path. After all, Chair Powell’s been telling us that a slowdown in the economy will not dissuade him from fighting inflation if it’s still an issue.

The good news is, if that happens, Treasuries might start functioning as a good hedge to stocks again. We’ve seen a few big down days in the equity market recently in which bonds are rallying, and that’s a distinct change.

And that brings us to the dollar. The dollar has been the market’s reliable safety trade the past year as investors turn to cash when stocks are in trouble. But that could get complicated from here as global central banks follow the Fed’s inflation-fighting policies and the dollar’s ascent becomes more challenging as growth improves in China and Europe. The dollar hasn’t broken its uptrend yet, but we’ve seen Treasuries do very well when stocks are selling off on recessionary fears. It's likely bonds will compete for dollars in a risk-off environment tied to economic weakness.

Trend is a trader’s friend, and the positive stocks-bonds correlation and negative stocks-dollar relationship are still in trend. Watch that yield curve to see if it compresses further, for signs the trends may change.

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