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The ‘Everything Rally’ May Be Over – And That’s A Good Thing

This week may have marked the end of the vaunted "everything rally", and that wouldn't necessarily be a negative development.

In the US, equities of course pressed to new highs, helped along by Jerome Powell's testimony on Capitol Hill, where the Fed chair essentially confirmed that a July rate cut is, in fact, the base case.

Of course, markets priced in a 25bp cut long ago, and that's precisely the point. As I've been over both on my site and on this platform on too many occasions to count, disappointing market expectations risks a tightening of financial conditions as falling stocks, rising yields, a stronger dollar and, with a slight delay, widening credit spreads, pose a spillover risk to the real economy, via the "wealth effect" channel, higher borrowing costs, etc. If that were acute enough, it would make a cut necessary anyway, so better to deliver now and call it "preemptive" than risk being seen as behind the curve or, to quote President Trump, "stubborn." That is most assuredly an example of the tail (i.e., markets) wagging the dog (i.e., Fed policy), but c'est la vie.

Notably, bonds were not along for the ride with stocks this week.

Since the June jobs report earlier this month, yields have pushed steadily higher. On Thursday afternoon, just hours after the hottest MoM core CPI read since January 2018 cast a bit of unwelcome doubt on the Fed chair's Wednesday efforts to walk back his "transitory" comments (from the May press conference) in favor of the notion that inflation might remain subdued for longer than the Fed expected, a very ugly 30-year auction sent yields surging. 10-year yields in the US are now all the way back up to 2.12%.

(Heisenberg)

On one hand, the above-mentioned 30-year auction was rather disconcerting, as it suggested some folks are at least cognizant of the possibility (however far-fetched it might seem now) that piling Fed cuts atop a five-decade-low unemployment rate risks a sudden resurgence of inflation pressures. Throw in the tariffs and stretched positioning in bonds (i.e., the "duration infatuation") and you've got a combustible dynamic that's conducive to a messy bond selloff at best, and a VaR shock at worst. You can read more on that here, but let's just ignore that for right now and focus on something simpler.

That stocks rose even as bond yields jumped is a positive development for equity bulls. 2019 has been dominated by the "bad news is good news" dynamic, whereby lackluster data and rampant trade uncertainty were seen as desirable to the extent they underscored the need for rate cuts and a renewed commitment to stimulus by central banks. As Goldman wrote earlier this week, "1H19 was mostly a ‘bad news is good news’ regime as softer global growth resulted in more central bank easing giving support both to ‘risky’ and ‘safe’ assets, which were sending conflicting bullish and bearish signals, respectively."

(Goldman)

Suffice to say not everyone believes that's a particularly healthy state of affairs. In addition to being counterintuitive outside of the post-crisis context, the obvious risk is that if central bank accommodation fails to avert a downturn, then bad news will just be plain old bad news as the economy careens into recession.

Given that, it's healthy if, at some point, overtly positive economic data (e.g., good jobs numbers) and signs that deflation might not be imminent (e.g., an above-consensus CPI print) aren't seen as excuses to dump risk assets because they might make central banks inclined to be less dovish.

That's why equity bulls should be happy to note that despite rising yields, stocks pushed to new highs this week.

(Heisenberg)

If this proves sustainable, it opens the door for good economic news to be greeted positively by equities, and it means the dreaded "jaws of doom" can close in a benign fashion that doesn't entail stocks "catching down" to bond yields that were basically screaming "recession".

(Heisenberg)

Of course, that "disconnect" was readily explainable both by way of expectations for stimulus and also in fundamental terms. I talked about it at length in these pages, and, in an interview with Goldman this week, Ray Dalio noted that he doesn't "see an inconsistency in the recent performance of stocks and bonds because stock values are fundamentally determined by the present value of expected cash flows, so, when the Fed shifted to a much easier stance, it made sense that both interest rates fell — which was good for bonds — and stock prices rose."

But at this juncture, it would be nice to see stocks hold up on fundamentally solid economic data even if that data doesn't necessarily argue for more monetary accommodation.

So, it looks as though the "everything rally" may be over if bond yields continue to rise. As detailed above, the simultaneous surge in equities and bonds had probably worn out its welcome anyway, to the extent it had become untenable by virtue of being based on the perverse "bad news is good news"https://seekingalpha.com/"good news is bad news" dynamic.

(Heisenberg)

In closing, let me briefly point out that with positioning in rates still stretched, and with duration risk running very high indeed, the risk is obviously that a rapid rise in yields causes a messy unwind. Generally speaking, stocks won't digest it well if yields rise too far, too fast. Simply put: Nobody wants a "tantrum" in rates.

Finally, earnings season is on deck, which gives equity investors a chance to focus on what "should" matter. That could be a good thing or bad thing depending on how things shake out.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.