Since the S&P 500 double-tested the 4,200 level two weeks ago, the market is up 8% in a straight line. If anyone would have mentioned Europe being tangled a major war with Russia as an invader -- while the world is flooded with heightened inflation and slowing growth -- one would have imagined risk assets and equities down much below the lows. Who could imagine them going up, instead? The problem is other asset classes are screaming signs of distress, which are getting ignored by equities altogether. So, which market is right and what is really going on?
The bond market has been in distress since the start of the year. The iShares 20-Plus Year Treasury bond exchange-traded fun (TLT) , as an indicator, is down about 12% year-to-date and the Investment Grade Bonds ETF (HYG) is down about 10%. This has been the worst performance of bonds to date. We know the bond markets are struggling as the Fed is still carrying on the remaining bit of its quantitative easing program from last year. It is quite astonishing to see that the Fed is still "adding" to its balance sheet when for the past month we have seen inflation numbers average 10% year-over-year with consumer confidence collapsing. Each Fed member has come out with strong statements how inflation has run away and the need to raise rates by at least a half a percentage point -- very strong jawboning. As of last Friday, the Fed's balance sheet grew by $50 billion over the past two weeks. The Fed has not even started selling assets, or "normalizing" yet. The rate of change of buying is small, but it is important to see how the markets behave in April once this support for the market disappears.
The overriding theme in bond markets is one of inflation. It does not trust the Fed, as the market senses the Fed is too late to the party and the move in the front of the curve is falling much faster than the back, a process called flattening, which is usually synonymous with bearish or recessionary markets. The spreads are collapsing and this morning one of the main indicators, the spread between the two year and 10 year bonds, finally fell below 0. This has been a very accurate representation of a recession over the past. The more the market prices in higher rates in the front, the bond market is pricing in more cuts in the future. This is the rational used by the equity market to condone further buying. But truth be told, the bond market does not trust the Fed, as it knows fully well, that the Fed is about 500 basis points behind the curve and needs to aggressively tighten. It also knows that the Fed cannot support the markets until inflation comes down to its 2% average.
Equities are the least sophisticated of all the macro asset classes. They tend to get pushed and pulled in all directions from flows of all types. This is one of the main reasons why it tends to get distorted from the bigger picture for some time, but it eventually plays catch up to the risk signaled in other markets. The March "quadruple witching" -- when stock-index futures contracts, stock options, stock-index futures options and stock index options expired -- caused massive futures hedging and a break higher due to the derivative positioning of the market. One must not forget that month-end and quarter-end flows tend to be big influencing factors, as well. Judging by the performance of equites over bonds, bond selling vs. equity buying window dressing is adding to this trend as well. To top it off, pure momentum chartists and fear of missing out traders seem to chase charts as we break technical levels to the upside.
It seems governments and markets alike have tried to place blame on the Russian invasion of Ukraine on everything, especially inflation. But inflation was a serious issue for the market well before this war started. Even if the war is resolved tomorrow, the Fed still faces the same dilemma it had back in January. This war has just shown how supply constrained this market is across the board.
Demand destruction is the only cure for inflation in a short period of time, because supply will play catch up, it just takes time. It is easy to look at just the technicals of the market, but that can give it a false sense of support, as technicals do not tell us where the market will go, it just tells us where it can get to if it moves in a certain direction. The bigger, broader macro cross assets are more revealing and significant; equities usually react to them, but with a time lag.
