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Investors believe the feedback loop between US stocks and bonds will likely be a key factor in determining whether the gyrations that have rocked markets this year continue into the last months of 2022.
With the third quarter over, both assets have seen painful sell-offs - the S&P 500 is down nearly 25 per cent year-to-date and the ICE BofA Treasury Index has fallen by around 13 per cent. The twin declines are the worst since 1938, according to BoFA Global Research.
Yet many investors say bonds have led the dance, with soaring yields slamming stock valuations as market participants recalibrated their portfolios to account for stronger-than-expected monetary tightening from the Fed.
The S&P 500’s forward price-to-earnings ratio fell from 20 in April to its current level of 16.1, a move that came alongside a 140 basis point surge in the yield on the benchmark US 10-year Treasury , which moves inversely to prices.
"Interest rates are at the core of every asset in the universe, and we won’t have a positive repricing in equities until the uncertainty of where the terminal rate will settle is clear,” said Charlie McElligott, managing director of cross-asset strategy at Nomura.
Volatility in US bonds has erupted in 2022, with this week’s Treasury yield gyrations taking the ICE BofAML US Bond Market Option Volatility Estimate Index to its highest level since March 2020. By contrast, the Cboe Volatility Index - the so-called Wall Street "fear gauge" - has failed to scale its peak from earlier this year.
“We have emphasised ... that interest rate volatility has been (and continues to be) the main driver of cross-asset volatility. Nevertheless, even we continue to watch the rates volatility complex with incredulity,” analysts at Soc Gen wrote.
Many investors believe the wild moves will continue until there is evidence that the Fed is winning its battle against inflation, allowing policymakers to eventually end monetary tightening. For now, more hawkishness is on the menu.
Investors on Friday afternoon were pricing in a 57 per cent chance that the US central bank hikes rates by 75 basis point rates at its Nov. 2 meeting, up from a 0 per cent chance one month ago, according to CME's FedWatch tool. Markets see rates hitting a peak of 4.5 per cent in July 2023, up from 4 per cent a month ago.
Next week’s US employment data will give investors a snapshot of whether the Fed’s rate hikes are starting to dent growth. Investors are also looking to earnings season, which starts in October, as they gauge to what degree a strong dollar and supply chain snafus will affect companies’ profits.
For now, investor sentiment is largely negative, with cash levels among fund managers near historic highs as many increasingly choose to sit out the market swings. Retail investors sold a net $2.9 billion of equities in the past week, the second largest outflow since March 2020, data from JPMorgan showed on Wednesday.
