Macro
FED’s preferred inflation gauge – Core PCE is expected to end the year at 2.6%. J. Powell said 3 inflation prints from the second quarter added confidence that the inflation rate is moving toward the FED’s target. As inflation came down better than FOMC expected, it is no longer a major concern, allowing the FED to have a more balanced focus on their dual-mandate view. Powell explicitly stated that any unexpected weakening in the labour market might prompt a reaction from the Fed. This nuanced approach indicates that the Fed is now equally concerned with maintaining employment levels while controlling inflation.
Going forward, the FED start putting more attention on the overall economy, especially the unemployment rate. In a full employment economy, the immediate response to a decrease in labour demand is more likely to be a reduction in job openings and a slowdown in wage growth rather than a rise in unemployment. With fewer new job opportunities, employees have less leverage to demand significant wage increases, leading to slower wage growth. The deceleration of income growth will eventually hurt consumption. Employers will try to avoid the costs and disruptions associated with layoffs and are limited by long-term contracts and other institutional factors. This is explained by the ‘sticky wages’ effect.
As we see, job openings have already sharply declined. This may eventually lead to an increase in unemployment and an increase in the risk of a recession. Unemployment is already starting to creep higher from multi-decade lows. As the unemployment rate is mean-reverting, it tends to increase sharply following a long descending period.
Rates
Odds of rate cust have increased this week in swaps and future markets. 2Y/30Y curve steepener went up 7 bps this week. People will be trading steeper, conforming to the view that the FED will be on the path to start cutting rates from September. However, due to political reasons, there is a high likelihood of beginning to cut after the November elections. The FED has stuck to its neutral stance despite the weakening of labour market data and the slowing of housing and real estate. If the economy weakens further, markets might reprice a series of rate reductions, leading to a bull steepening of the curve.
We just went through the period of highest inflation since the 1970s, and the rate did not cross the 5% bound. Now, inflation has mostly normalized. This means that this is an upper bound for the rate for the next decade. This will give the market more confidence about the range of policy rates.
Given the current economic landscape, long-duration exposure is deemed sensible. The bull case for bonds aligns with the classic end-of-cycle trade. In the current environment, investors prioritize safe yields over high yields. This trend is driven by the need for stability amid potential economic uncertainties.
The terminal rate price is now just under 3.5%, which is expected to hit by mid-2026. This is roughly where investors expect the ‘neutral rate’ to be, which means if the economy slows significantly, the FED is expected to cut below that rate.
Credit
US credit markets are navigating a complex landscape influenced by rate cut expectations, inflation normalization, upcoming elections, and a slowing economy. As the economy weakens, default rates can rise from the multiyear low. Volatility can also pick up as we approach elections. Spreads might start to widen from their current near-all-time tights.
US High-Yield (HY) bonds are caught in Trump’s rally. As ex-financial, nearly half of the junk rate borrowers have only domestic revenue and will benefit from Trump’s protectionist stance. Furthermore, the lower corporate tax rate Trump promised to bring will help with their interest coverage ratio and overall creditworthiness.
US junk bonds just scored their longest winning stretch since 2020, returning 0.3% this week and 0.8% a week earlier. With spreads at 303 bps and yields still hovering near the 2024 low of 7.60%. Volumes increased to $3.78 from $2b last week but are expected to slow next week, ahead of jobless claims data. HY ETFs attracted $1.1b inflows the previous week for a year-to-date total of $7.5b. There was no change this week in the pricing of a HY CDS.
The cumulative 12-month bond default rate is declining and now approaching 2% or $23b in pair value. At the same time, chapter 11 bankruptcy filings have been rising from post-pandemic lows and are now above 2014-2019 levels, approaching 8k for TTM.
Equity
Stocks sold off this week, especially tech stocks, with the worst week for the Nasdaq 100 in 3 months. As technology giants prepare for earning season, investors expect their earnings growth to slow. Technology valuation are significantly above the historical average, and with analysts revising their estimates higher, any earning misses might be severely punished. Two names were in focus. The first one is Nvidia, which is losing momentum and is now hovering over its 50 DMA after it sank 8.8% this week. Potential breakdown and sharp decline would significantly affect the index valuation and overall market sentiment.
The second one is Crowdstrike, which dominated the discussion on Friday. The stock declined over 15% on Friday’s opening (ending up -11.1 % for the day) due to the release of a software update that had a bug that hit almost all Microsoft products. The bug was fixed, and Crowdstrike is working with each customer to help them to get back online. However, it caused a major disruption, and certain companies took a while to reboot and get back online. A tiny “C-00000291*.sys” file caused the incident to affect 8.5 million Windows computers and exposed fragility in the global IT system. Over the years, consolidation in the security industry has brought centralization of decision-making and has drastically increased the consequences of errors.
The Incident was a major setback for Crowdstrike. This cybersecurity disaster never seen at this scale will hit the company’s reputation and give an advantage to its competitors. It will also prompt many companies to ask about the concentration of their exposure to key software providers and, more specifically, to diversify away from a single cybersecurity provider. It may also prompt questions about forced global software updates, which simultaneously hits all global users.
As tech stocks sold off, we have seen a response in options volume as investors buy calls to respond to a dip in the biggest option volume spike this year. Investors are buying in the dip using ETFs. US equity ETFs took in $15b on Friday and $60b this week. This gives a record flow 5-day average of $12b and $141b 1-month average. Most of the money comes from cash deposits, cash funds, and money market funds, as investors feel FOMO and pile into the stock market.
While major indexes and tech sold off, the small caps had a massive outperformance (although they sold off on Thursday and Friday). The strong performance of the small caps over the last two weeks can be attributed to increased expectations of a potential Federal Reserve interest rate cut, which investors believe would benefit smaller companies disproportionately.
Small caps outperformance was associated with dynamic ‘breadth thrust’ (technical indicator of momentum, signalling the potential start of a bull market), with 75% of the Russell 2000 stocks hitting their 1-month high this week. As with any such a strong move, it has been led by low-quality names reversing back from their distressed valuations. From a technical perspective, a significant breadth thrust after coming off major lows is a very bullish signal. The bar for the small caps to outperform is incredibly high, as they’ve been lagging for a while now. Rusell 2000 had the 4th longest recovery period in its history, with 675 days without a new high. Rusell 2000 is not only lagging large caps but also its own average historic move off the lows. On average, return on a 1-year recovery from major lows, Rusell 2000 returns 50-60%, while this time index is up only 25%.
We can also see broadening out on the broader index, with 19% of Russell 3000 stocks hitting a new all-time high. This level of participation might be short-term overheating, but historically, it has been bullish and led to above-average performance in the following 6-12 months.
Although it is likely that small caps will broaden their participation in the rallies, it is still being determined if they will outperform large caps in the long run. Usually, small caps outperform in the periods of coming out of recession. Thus, it is still being determined whether this momentum can take over large caps over a 6-12-month horizon. From the flow perspective, small caps are still facing outflows, and over the last 6 months, small caps had the lowest flow since the market bottom in 2022, and historically this has been a bullish positioning signal. As Russell 2000 has many low-quality names, security selection is critical, and preference is skewed towards active strategy.
We also had massive outperformance of the S&P EW vs. S&P Cap weighted, with 61% of S&P 500 stocks outperforming this index over the past 30 days. From a sector perspective, this is led by financials, industrials, and healthcare, which have joined the rally. With their relatively cheap valuations, they have a lot more room to run than mega-cap tech, which now shows signs of exhaustion.