Treasuries On The Right Path

Japan Remains A Risk

Volatility has become incredibly subdued again with the VIX approaching its lowest levels of 2023. With high yield spreads also retreating to some of their lowest levels of the year, it’s created a short-term environment conducive to risk-taking. Overall, we’ve seen small-caps and micro-caps trying to lead in fits and starts, but nothing that would suggest we’re entering a long-term risk-on regime at the moment. The one consistent feature we’ve seen throughout November is investors returning to the comfort of mega-caps and tech stocks even as conditions continue to evolve. That type of behavior isn’t necessarily unusual around this time of year, but it also doesn’t indicate a market that is broadly gaining across the board. Small-caps and value stocks are still trailing large-caps by about 17% year-to-date and we need to see those two groups perform much better before we can have the conversation about a sustainable equity market rally.

The latest Fed meeting minutes indicate that while the central bank’s policy stance appears neutral at a high level, the familiar refrains of “higher for longer” and “we won’t hesitate to tighten further” are still in scope. In particular, there was no real mention of the potential for interest rate cuts, although the markets have been pulling forward their timeline for such an event. The futures market is currently pricing in a nearly 30% chance of a rate cut at the March meeting and an 80% chance by the June meeting. The contrast in positioning raises the possibility of higher volatility heading into the new year as expectations become more aligned. The Fed has been notoriously (almost embarrassingly) slow in reacting to changes in conditions and I don’t suspect 2024 will be any different. While the concern that inflation is still running above the Fed’s 2% target is appropriate, the rate of change on inflation confirms we’re quickly heading towards that number and there’s little evidence that the sudden return of inflation is a high risk at the moment. Any further tightening at this point would almost certainly just accelerate the path towards outright deflation and recession. The fact that further tightening is still being threatened by Powell is confusing at best and irresponsible at worst. The markets certainly aren’t buying the argument.

Treasuries, however, look like they’re on the right path. Yields on the long end of the curve continue to decline as the data supports the notion of cooler activity moving forward. This week’s 20-year Treasury note auction saw relatively strong demand and should help offset some of the concern that the dismal 30-year auction earlier this month was a sign that there was an oversupply of government bonds in the market that could force yields to move higher again. While that pushes the 10Y/2Y spread further into negative territory, it does help confirm the market’s belief that interest rates could keep heading further down and investors are trying to lock in today’s higher rates for longer.

Overall, this will probably be a week of very little volatility and the potential for slight to modest gains, but next week could set the tone. That’s when we’ll start hearing about Black Friday sales figures and spending that will likely give us a good idea of just how resilient the consumer will be this season.