Stock market clues from the bond market

Clues from the bond market

The S&P 500 made a marginal all-time high last week and pulled back. However, investors may find insights about the near-term outlook for equities from the bond market.

The accompanying chart shows how the VIX Index (middle panel, red dotted line, inverted scale) and MOVE Index (middle panel, black line, inverted scale), which is the VIX of the Treasury market, have mostly normalized their episode of pre-election anxiety. However, MOVE hasn’t fully normalized compared to VIX. I interpret this to mean that there is more room for Treasury yields to fall (bottom panel), which would be supportive of equity valuation.

The combination of sentiment returning to pre-election levels and the S&P 500 remaining in a well-defined uptrend leads me to believe that stock prices can continue to rise into year-end.
 

 

 

A bond market turnaround?

After a brief pullback that began in September, bond prices may be poised for a turnaround. Nautilus Research documented that we are approaching a period of a positive seasonality for the price of the 20+ Year Treasury ETF (TLT).

Bloomberg also reported that option traders are betting on a deep Treasury sell-off, which is contrarian bullish for bond prices from a sentiment viewpoint.
 

 

 

Bessent’s 3-3-3 plan

Trump’s announcement of Scott Bessent as Treasury Secretary seems to have cheered the bond market. Bessent’s 3-3-3 plan for the second Trump term has calmed the markets. The 3-3-3 plan consists of reducing the fiscal deficit to 3% of GDP from 6.3% today by 2028; boosting real GDP growth to 3%; and raising U.S. energy production by 3 million barrels per day.

Bessent has shown himself to be a fiscal hawk and supporter of an independent Fed, which should be a relief to Wall Street. Since the news of his proposed nomination, reporters have scoured the internet for his views during his tenure as a hedge fund manager.

When Trump began to criticize the Fed for raising rates in 2018 in the wake of his tax cut bill, Bessent told the Australian Financial Review that the “late cycle stimulus” was like “throwing nitroglycerine in the engine” and compared the episode to LBJ’s guns and butter stimulus of the late 1960s. At the time, not only did he support the Fed’s decision to raise rates, but he also believed that the Fed was late in its rate hike cycle: “The Fed wanted to be behind the curve, but now they are behind the curve.”

In response, the 10-year Treasury term premium, which is the increased yield investors demand to hold long-dated debt, has steadied at elevated levels. Gold prices also pulled back, though the decline could be partly explained by a compression of the geopolitical risk premium from the news of the Israel-Lebanon ceasefire agreement.
 

 

In reality, Bessent’s views are a mixed bag, and they may not be as market friendly as conventional wisdom would have it. His hedge fund quarterly letter dated January 31, 2024 revealed a view that’s bullish on the Trump agenda: “Our base case is that a re-elected Donald Trump will want to create an economic lollapalooza and engineer what he will likely call ‘the greatest four years in American history’” and dismissed the threat of “the tariff gun will be always loaded and on the table but rarely discharged.” Instead, “Trump will pursue a weak dollar policy rather than implementing tariffs. Tariffs are inflationary and would strengthen the dollar – hardly a good starting point for a U.S. industrial renaissance. Weakening the dollar early in his second administration would make U.S. manufacturing competitive…and plentiful, cheap energy could power a boom.” Weakening the currency instead of using tariffs as a blunt instrument of trade policy – that’s the good news.

The bad news is he is unlikely to be overly bond market friendly. In a separate podcast, Bessent revealed that he is a gold bull: “I think we’re in a long-term bull market in Gold. We’re seeing reserve accumulation by Central Banks. I follow it closely. It’s my biggest position. Even I was surprised when the Central Bank of Poland said they want to take their Gold reserves to 20%.”

As well, a WSJ profile indicated that he plans to extend the TCJA tax cuts using pay-fors by “freezing nondefense discretionary spending and overhauling the subsidies for electric vehicles and other parts of the Inflation Reduction Act.” In other words, don’t expect any massive fiscal stimulus that provides fuel for equity prices.

Bessent faces additional pressure from refunding policy changes at the Yellen Treasury. When Biden took office, the average maturity of Treasury debt was about seven years, which means that financing rates are locked in for seven years before they have to be refinanced. Treasury Secretary Yellen has been changing the Treasury debt profile by issuing more T-Bills than coupons and the average maturity is now about four years. With rates now higher, Bessent will face inevitable interest rate costs in the budget as the U.S. Treasury refunds its debt. If he were to extend the term of Treasury issuance, it would put upward pressure in the mid and long end of the curve, putting downward pressure on both stock and bond prices.
 

 

Party now

In conclusion, investors can enjoy the party during this quiet interregnum period. Jeffrey Hirsch at Almanac Trader documented how price momentum can beget more momentum. Strong price gains before U.S. Thanksgiving tend to resolve in average gains of 2.4% into year-end.
 

Party now. January and beyond may be a different story.

My inner trader remains tactically long the S&P 500. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long SPXL