Andrew Pyle
January 19, 2024
Some normalization in volatility and yields is to be expected
Last month, we witnessed a sea-change in market sentiment from the nervousness in August to October. Investor optimism was fueled by prospects for falling interest rates without the need for a hard, or even soft, landing. Some bond yields had experienced the largest two-month decline on record and major equity benchmarks were approaching record highs or, in the case of the NASDAQ, making new ones. At the same time, volatility was heading down and the outlook looked golden for 2024. As I commented a couple of weeks ago, this optimism was beginning to fade. Three weeks into the new year and there hasn’t really been a capitulation, though we are seeing markets behaving a little more rationally; That’s not a bad thing.
Let’s start with gyrations in the stock market. On December 12th, the Chicago VIX index closed at 12.07 – the lowest it had been since November 2019. That was close to a 10-point reversal from the highs in October and a 14-point drop from levels seen in March of last year, during the U.S. banking drama. The decline in the so-called “fear index” was consistent with the elevated mood on the street and was reminiscent of previous market cycles.
The above chart shows the VIX index over the past 30 years and you will notice that we have been at these levels a number of times, but it rarely moves below 10. When it does, there tends to be a sharp reversal higher. Those increases don’t always coincide with a significant correction in stocks, but it did occur after the November 2019 low, and again after approaching this threshold in the summer of 2014 and, of course, back in 2007. On Wednesday of this week, the VIX came close to hitting 15, which is a return to levels we saw in the early part of November. The question then is where is the gradual creep higher volatility coming from?
First, let’s put this in perspective. Rather than representing a spike in investor concern, this move simply takes us back to the average for the VIX over the past 12 months, or roughly 16. On an annual basis, this is the lowest average since 2019. That said, a reversion to even a lower mean does suggest the market is coming to terms with a more realistic path for monetary policy, a potential widening of hostilities in the Middle East and the fact that close to half the world’s population will be voting in elections this year.
Since Jerome Powell gave the game away after the December FOMC, regarding a pivot to lowering rates, the market has run away with it. The result has been speculation that the Fed will begin cutting rates as soon as this March (some even saying this first move could be a half of one percent!) and that cumulative easing might be as much as 1-1/2 to 2 percentage points. There have been some indicators that would appear to support a view of lower official rates (such as this week’s U.S. producer price data), but this was more than offset by a stronger-than-expected December retail sales report and then a surprise decline in initial jobless claims last week to 187,000. That is the lowest since September 2022 and suggests that the U.S. labour market is far from rolling over.
As a result, the downward trend in U.S. bond yields since October looks to have hit at least a temporary speed bump. The government 2yr note has bounced off of last week’s dip below 4.2% to return to close to 4.4% as we head into the weekend. Not a major move, but still a net retracement from the end of December. The move in the 10yr yield, however, is a little more pronounced, as the above chart shows. After reaching a closing low of around 3.85% in late-December, we have now moved back up to the 4.15% area. Some of this coming from a partial unwinding of Fed easing expectations, but it is also picking up a lack of confidence in the ability of the U.S. to rein in an excessively large budget deficit. We typically don’t look to election years for hard work on bringing budget deficits down. Technical resistance for the 10yr yield is up around 4.25%, which also represents a 38.2% retracement of the rally from October to December.
Some are applauding the development of an increase in longer-term yields against a sideways move in shorter dated bonds, as this gets us out of a situation where the U.S. yield curve was extremely inverted – meaning short-term yields were well above long-term ones. Economists typically ascribe higher probabilities of a recession when we have an inverted curve, and this was one of the reasons economic predictions were so dire a year ago. If we use the spread between 2yr and 10yr yields, the depth of inversion back in the summer was wider than minus 1% (100 basis points). Today, that spread is minus 0.2% - more or less on par with where it was in October.
It’s useful to point out that last summer, the 2-10yr segment of the U.S. yield curve was the most inverted since the early 1980s. It exceeded the period prior to the great financial crisis and also the start of the tech bubble pop in 2000. The fact that the equity market would be so cheerful simply because we have seen the curve go from minus 1% to minus 0.2% (in other words, we are still as inverted as back in 2006) is a little curious.
If things evolved to the point where the yield curve was back to being normally shaped, then this might dispel any negative thoughts of the economy and therefore stocks. The problem is that there a limited number of paths to get there. We could get what the bulls want and that is a series of Fed rate cuts alongside a cooling, but not contracting economy. If inflation fell to 2%, allowing the Fed funds rate to move back to say 3%, then this would likely move the 2yr yield to a similar level. But, if growth were sustained in the economy, then the 10yr yield would have a hard time getting much below 3.5%. The result – a positively sloped curve.
There are two other ways to get that type of curve, but they are not as blissful. One would be a shock to the economy or financial system that requires a rapid easing response by the Fed. Right now, there doesn’t appear to be any major red flags. Sure, delinquency ratios might be creeping higher and there is an ever-larger participation by non-banks in the credit space, but nothing like the 2007 experience. That said, there is a similarity to that period that shouldn’t be overlooked and that is the length of time between the last Fed hike and the first cut.
As I discussed well back in 2022, it isn’t always the extent of central bank tightening that creates a recession, but how long we have to wait for the pivot. The 2006-07 period was a perfect example of what happens when the Fed is late to the easing table. In that case, the wait was just over a year. Well, the last rate hike by the Fed this cycle was last July. No one expects them to cut at the January 31st meeting and odds are slipping away for a March move. That leaves June and July. On Thursday, Atlanta Fed President Raphael Bostic said that he didn’t believe the Fed would lower rates until the third quarter, which would put us pretty close to the 2006-07 experience.
Suffice to say, this is not what market participants were thinking in December. That’s not to say President Bostic is right either, but enough reflection has been injected to provide some second-guessing. To be fair, no central bank out there has the complete playbook, because we have never gone from pandemic to extreme stimulus to extreme tightening before. The Fed does know that there are risks in stretching the rubber band too far, but the resilience in the economy could nudge them in that direction. They have seen what happens when monetary policy is eased too soon, like during the 1974-76 episode. Back then, the Fed lowered rates from a peak of 13% to 4.75%, but then had to reverse course and send rates to 20%. Lesson learned.
Bottom line, the uptick in market volatility shouldn’t be a surprise as investors recalibrate to this normalization in interest rate expectations. Bonds could give back even more ground, but I think you will see money being put to work on yield increases. We are already seeing a strong appetite for new corporate bond issuance this month. Whether the stock market has fully come to grips with a longer pause by the Fed before cutting remains to be seen. A rise in bond yields and an uptick in market volatility is normal at this stage, in our opinion, and doesn’t necessarily point to a major pullback in equities. Still, if the market is mispricing the direction of rates and/or state of the economy, then we would expect better opportunities to re-invest cash down the road.
On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.
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