Squeezes And Pivots

The nascent recovery in beleaguered stocks is rational, but if you ask one popular sell-side strategist, US equities’ best month since November of 2020 still constitutes a head fake.

“Since the catalyst for the bear market was a repricing of interest rates,” the rebound in equities “makes sense” in the context of falling yields, BofA’s Michael Hartnett said, in the latest installment of his popular weekly “Flow Show” series.

Bonds had a good month too, delivering relief to multi-asset investors beset by 2022’s simultaneous drawdown in virtually all assets save commodities. July was the first time a popular Treasury ETF rallied alongside equities in nine months (figure below).

Real yields repriced sharply lower on the heels of the July FOMC meeting, a move many analysts suggested was indicative of a traders misreading Jerome Powell’s press conference. Whatever it was, the extension of the rally in bonds (and the attendant repricing of the terminal rate) was rocket fuel for stocks, and particularly tech shares.

I’d note that the bond rally has been driven in part by short covering and CTA flows. On Friday, for example, some trend following strats may have flipped long after 10-year note futures rallied through key trigger levels, according to one major Wall Street bank. Similarly, Nomura’s Charlie McElligott estimates that CTA buying and short-covering across G10 bond positions amounted to more than $30 billion over the past week.

Long-end yields were richer into afternoon trading Friday despite (or perhaps because of) hotter-than-expected reads on wage growth and inflation, which together argued for a more aggressive Fed to the possible further detriment of already slower growth.

Lower yields are a boon to long-duration equities. And growth shares dominate US benchmarks. It’s thus no surprise that stocks have rallied sharply off the lows, aided and abetted by solid tech earnings and a kind of synthetic short squeeze from the closing of hedges as spot rallied (aggressively) away from downside strikes (figure below).

“This all comes with ‘Gamma vs Spot’ positioning now back very comfortably ‘Long’ for Dealers [and] getting longer as iVol bleeds to death,” McElligott said Friday.

Still, there’s widespread skepticism about the staying power of the stock recovery. “We remain of the view that this is a bear rally and would fade SPX >4,200,” Hartnett wrote, suggesting the “true lows” for the S&P are below 3,600.

For a Fed pivot, you need five catalysts, he went on to say. True to form, Hartnett made it fun — he spelled out “PIVOT.” To wit:

Payroll: payrolls <100k, initial unemployment claims >300k,

Inflation: headline & core CPI prints of 0-0.2% (would still leave headline >6%, core >4% year-end),

Volatility: VIX >50, / MOVE >150, HY spreads >600bps,

Oil: WTI <$80/barrel,

Treasurys: yield curve inverts into recession, but always “bull steepens” as recession begins.

We haven’t checked any of those boxes yet. Until we do, stocks may have a difficult time sustaining a rebound.

Hartnett also refreshed a familiar chart. The figure on the right (below) shows how hard it’ll be for inflation to recede materially in the near- or even medium-term.

There’s no prospect of inflation reaching target by December, although I doubt anyone was under the impression that such an outcome was feasible. Certainly the Fed doesn’t expect any such thing, and they’ve been an optimistic bunch, to the detriment of their credibility.

The figure on the left (above) is also familiar. As difficult as a tsunami of recession headlines are for the Biden administration, the reality of 9% inflation is far worse.

Although I doubt the White House believes Fed hikes are the best medicine, if there’s even an outside chance that Powell can cajole inflation lower without costing the economy too many jobs, the Oval Office will begrudgingly acquiesce, comforted in the notion that if all else fails (and it might), Biden can just blame Powell — both for inflation and the recession.

Read more: Biden ‘Not Surprised’ Fed Kneecapped ‘Historic’ Economic Boom