© Reuters. FILE PHOTO: Traders work on the floor of the New York Stock Exchange (NYSE) in Manhattan, New York, U.S. September 13, 2022. REUTERS/Andrew Kelly/File Photo
By David Randall
NEW YORK (Reuters) – Investors are betting the feedback loop between U.S. stocks and bonds is likely to be a key factor in determining whether the swings that have rattled markets this year will continue into the final months of 2022.
As the third quarter draws to a close, both assets have seen painful selling, with the year-to-date down almost 24% and the ICE (NYSE:) BofA Treasury index down around 13%. The twin declines are the worst since 1938, according to BoFA Global Research.
Yet many investors say bonds led the way, as yields soared to account for the Federal Reserve’s drastic monetary tightening, upending stock market valuations while raising the cost of borrowing for customers and businesses.
Equity valuations have cratered as yields have risen, with the S&P 500 forward price-to-earnings ratio falling from 20 in April to a current level of 16.1. The yield on the benchmark 10-year US Treasury note rose about 140 basis points over this period.
“Interest rates are at the heart of every asset in the universe, and we won’t have a positive revaluation of equities until the uncertainty of where the terminal rate will settle is clear.” , said Charlie McElligott, managing director of multi-asset strategy. at Nomura.
US bond volatility has flared in 2022, with this week’s swings in Treasury yields taking the ICE BofAML US Bond Market Option Volatility Estimate Index to its highest level since March 2020. “Gauge” – failed to reach its peak at the start of this year.
“We have emphasized (…) that interest rate volatility has been (and continues to be) the main driver of multi-asset volatility. Nevertheless, even we continue to look at the rate volatility complex with disbelief,” Soc Gen analysts wrote.
Charts: Bonds Breaking Down – https://fingfx.thomsonreuters.com/gfx/mkt/akpezdaxjvr/Pasted%20image%201664460769205.png
Many investors believe the wild moves will continue until the Fed is proven to be winning its battle against inflation, allowing policymakers to end monetary tightening. For now, more hawkishness is on the menu.
Investors are now pricing in a 62% chance of the U.S. central bank raising rates by 75 basis points at its Nov. 2 meeting, up from 0% a month ago, according to CME’s FedWatch tool. Markets see rates peaking at 4.5% in July 2023, up from 4% a month ago.
Next week’s US jobs data will give investors some insight into whether Fed rate hikes are starting to dampen growth. Investors are also looking to earnings season, which begins in October, as they assess how a strong dollar and supply chain failure will affect corporate earnings.
For now, investor sentiment is largely negative, with cash levels among fund managers near all-time highs, as many increasingly opt to stay away from market swings. Retail investors sold $2.9 billion net worth of stocks over the past week, the second largest outflow since March 2020, according to JPMorgan (NYSE:) data released Wednesday.
Still, some investors think a rally in stocks and bonds could soon be on the horizon.
Sharp declines in both asset classes make them an attractive investment given the likelihood of longer-term returns, said Adam Hetts, global head of portfolio construction and strategy at Janus Henderson Investors.
“We’ve been in a world where nothing worked. Most of that agony is over, we think,” he said.
JPMorgan analysts, meanwhile, said while a “bull market in equities might necessitate a bull market in bonds,” high cash allocations could provide a safety net for stocks and bonds, likely limiting declines. future.
At the same time, the fourth quarter is historically the best time for returns for major U.S. stock indices, with the S&P 500 posting an average gain of 4.2% since 1949, according to the Stock Trader’s Almanac.
Of course, bottom buying has done poorly this year. The S&P 500 has mounted four rallies of 6% or more this year, with each rebound followed by new bear market lows.
Stocks may have fallen more than bonds given the high likelihood of a recession in 2023, said Keith Lerner, co-chief investment officer and chief market strategist at Truist Advisory Services.
“We think the upside in equities will be capped as there will be more headwinds in earnings and more central bank tightening,” he said.