/ April 14 / Weekly Preview
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Monday:
N/A
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Tuesday:NY Empire State Manufacturing Index (-14.8 exp.)
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Wednesday:
Retail Sales MoM (1.3% exp.)
Fed Chair Powell Speech
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Thursday:
Housing Starts (1.41M exp.)
Initial Jobless Claims (224K exp.)
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Friday:
N/A -
Monday:
Goldman Sachs
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Tuesday:Johnson & Johnson
Bank of America
Citigroup
Interactive Brokers
United Airlines
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Wednesday:
Abbott Labs
ASML
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Thursday:
UnitedHealth Group
American Express
Charles Schwab
Snap-On
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Friday:
N/A
Soaring Yields Issue A Warning
Last week saw volatility continue in financial markets as two key events rocked both stocks and bonds. Trump’s “pause on tariffs” announcement on Wednesday sent equity markets screaming higher, while a hedge fund unwind of leveraged trades hit the bond market simultaneously. We wouldn’t be surprised if these two were linked somehow, as treasury liquidations usually occur under equity market stress.
To start with, the trade war was getting hot, with China retaliating against US tariffs, with import duties of their own. The market was not expecting this and stocks outright crashed. On Monday, we suspect there was an intentional “leak” by the White House to test the market response in the event of a tariff pause. S&P 500 futures rallied more than +8.0% on the rumour and then retraced most of the gains. Eventually, as the bond market came under significant stress, Trump announced the tariff pause.
Here’s the full statement:
As expected, stocks surged right back to technical resistance levels in a historical 1-day rally. From there, a wide oscillation then occurred, as many investors are in a “trapped long” situation, where rallies are immediately met with significant selling.
However, the stage is set for a continuation of the rally this week, given the improvement in both morale and short-term technicals. For now, we see the markets holding support at recent lows, with a rally target at $565.
Within a broader context, SPY is still trading below levels that would allow our main allocation strategy (Enterprise) to include it in portfolios. A close above $544 is needed by tomorrow. Furthermore, the break of the technical channel lower trendline puts us in “sell the rally” mode, as these price drops tend to align with more extensive correction processes.
The closest analog to today’s setup is 2022, when the market eventually reverted valuations to -2 standard deviations (18.5x P/E) in a 10 month long bear market. The maximum drawdown in the S&P 500 for that period was -24% at the lowest.
Today’s market currently exhibits a -12% drawdown and a reversion of valuations to the cycle median (21.4 currently). In this sense, there is still room for a further realignment, especially in the scenario where EPS will fail to keep up with increased expectations. Eventually, the market will find an equilibrium point and rally from there, as was the case every time. However, the timing of that equilibrium point is becoming increasingly uncertain.
Credit spreads are a signal that we are closely watching in times of market stress. Credit spreads indicate the level of risk associated with corporate bonds in comparison to government bonds. When the economy is doing well, the gap between higher-risk corporate bonds and more secure Treasury bonds tends to be narrow, as investors have confidence in corporate earnings and are prepared to accept lower yields in exchange for taking on higher risks. However, during times of economic uncertainty or distress, investors seek higher yields for holding corporate debt, leading to an increase in spreads. This widening often reflects growing concerns about potential corporate defaults, which may signal broader economic difficulties.
As such, paying attention to credit spreads provides insights into the health of the corporate sector, which is a major driver of equity performance. Widening credit spreads are commonly associated with increased risk aversion among investors. Historically, significant widening of credit spreads has foreshadowed recessions and major market sell-offs.
The recent market volatility occasioned by Trump's trade war has clearly increased the gap between "risk-free" treasury yields and corporate bond yields. Nonetheless, despite this widening, the spreads are still considerably below long-term averages. As inflation and economic growth decelerate, the recent turmoil in the Treasury bond market serves as an indication of more than merely recession-related fears.
On Monday, Treasury bonds experienced a significant decline that greatly exceeded what the economic and tariff data would have indicated. We suspect that this drop was driven by forced liquidations due to margin calls or redemptions from one or more institutional funds. The level of selling and volume observed in a single day for bonds is highly atypical. Media explanations citing “tariffs” or “economic concerns” fails to acknowledge that these issues have long been known to the bond market.
Such rapid repricing has historically been associated with “liquidity events” in treasuries. In this instance, it seems to be linked to the heavily leveraged arbitrage trades employed by hedge funds. Whenever totally unexpected market events occur, margin calls kick in. Funds are then forced to liquidate assets posted as collateral, which only deepens the selloff and threatens the stability of the whole system.
Eventually, the Fed is required to step in, using emergency purchases of US Treasuries.
Credit spreads and interest rates are indicating potential issues, but they have not reached levels that imply a complete breakdown of the funding market. The bond market remains operational, as evidenced by a successful 10-year auction held on Wednesday.
Additionally, the administration’s 90-day suspension of tariffs may represent a positive move toward either fully resolving the trade war or at least significantly diminishing it. It is our belief that the treasury market was the main catalyst for the decision to pause tariffs and not the turmoil in the stock market.
Hence, now appears to be an excellent time to add treasuries to portfolios, despite the implied volatility. The MOVE Index, often called the "Bond Market VIX," measures expected volatility in the U.S. Treasury market. It tracks how much investors think Treasury bond yields might swing in the near future, based on options prices for Treasuries. As evidenced in the chart below, the MOVE index has spiked to near record levels since 2022, signaling very high uncertainty.
Our Trading Strategy
The corrective cycle appears to have officially started. Despite last week's significant reflexive rally, the market action closely aligns with the 2021-2022 period.
Should we enter another similar bear-market phase, the existing technical parallels provide a valuable framework to navigate. In 2022, the Federal Reserve was raising interest rates, inflation was on the rise, and everyone believed a recession was imminent. At that time, revised lower earnings estimates prompted a valuation reset.
Currently, the Fed is reducing rates and inflation is tracking lower. However, the repercussions of Trump's trade policies are escalating the risk of recession, while earnings estimates continue to be overly optimistic. As analysts lower the euphoric price targets set in December 2024, it is becoming increasingly clear that stock market all-time-highs might not be happening any time soon.
With this understanding, we need to continue to rebalance equity risk lower, using rallies for opportunistic selling. The “decline, rally, decline” process is a part of bear markets until the final bottom is found. In any case, lows are more often than not retested.
Whenever internal metrics start to improve and positive divergences are detected, we will shift bond allocations from treasuries to corporates and increase equity risk exposure. For now, “defense” is the name of the game.
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