According to Thierry Wizman of Macquarie, the Federal Reserve is holding onto its “higher-for-longer” interest rate stance until it detects vulnerabilities in the consumer side of the market. The recent turbulence in the world’s largest bond market has put U.S. stocks under pressure, as investors grapple with the prospect of sustained high interest rates extending into 2024, pending a decrease in underlying inflationary pressures.
The U.S. Treasury market, a cornerstone of the global financial system, has endured a series of sell-offs since late September, driving yields on 10-year and 30-year Treasurys to levels last witnessed during the lead-up to the 2008 financial crisis before experiencing a recent decline.
In September, a bond market sell-off was spurred by the Federal Reserve’s hawkish outlook, coupled with concerns about the U.S. fiscal deficit, federal debt, and the potential for a government shutdown if the 2024 fiscal year budget remains unresolved by mid-November.
However, this week, heightened uncertainty surrounding the Middle East conflict led to increased demand for safer assets, causing long-term bond prices to rise and yields to fall. On Thursday, a Treasury bond auction resulted in decreased demand, despite notably higher yields, leading to another uptick in longer-term rates. Simultaneously, investors were confronted with inflation data indicating elevated consumer prices in September, which contributed to a decline in U.S. stocks.
Investors are now questioning the conditions necessary for interest rates and bond yields to decrease in the coming months, potentially boosting stock markets as they approach year-end.
Tim Hayes, the Chief Global Investment Strategist at Ned Davis Research, suggests that excessive pessimism in the bond market could set the stage for a relief rally in both stocks and bonds. According to Hayes, there may be less inflationary pressure than the market has anticipated, and a shift in sentiment in the Treasury market may drive bond yields lower, benefiting equities.
However, some analysts argue that disinflation might not be sufficient to prompt the Federal Reserve to abandon its “higher-for-longer” interest rate narrative, which has been a major driver of the surge in yields since September. Thierry Wizman of Macquarie believes that a slowdown in the consumer sector is necessary to alter the Fed’s stance and encourage a more flexible long-term outlook among policymakers.
While the Fed is not currently signaling a removal of the “higher-for-longer” narrative, Wizman is confident that U.S. consumption data will weaken in the coming months, potentially due to consumer-product and -service companies providing guidance for the fourth quarter and consumers adjusting their spending for the holiday shopping season.
While a consumer-side slowdown could benefit bonds, investors should remain cautious about buying into the stock market, as stock valuations could still appear elevated with Treasury yields at 16-year highs.
The “higher-for-longer” narrative has been used by Fed officials to indicate the potential for sustained higher interest rates. However, Wizman sees it as a “publicity stunt” designed to tighten financial conditions in the short term.
If consumer sector slowdown and ongoing disinflation can temper the Fed’s rate expectations, Treasury yields may continue to decline without requiring a major economic downturn. Additionally, the historical seasonality of the stock market suggests the possibility of a rally, as the fourth quarter has historically been strong for the U.S. stock market.
The S&P 500, Dow Jones Industrial Average, and Nasdaq Composite have shown positive movements in the fourth quarter, contributing to the growing sentiment that bond yields may have reached their peak and equities could rally towards the end of the year. Yields on 10-year and 30-year Treasurys have experienced recent declines, with the 30-year yield posting its largest weekly drop in a while.
