posterous kontent

One stronger-than-expected payroll report, and short-rate markets are focused on the prospect of a Fed tightening. A few thoughts:

First, short-end rates remain at very low levels, despite the post-payroll jump. The two-year note, for example, lifted from under 1% to over 1.4% by Monday's close (Exhibit 1). Jim Caron, our head of rates strategy, believes that the spike has been exacerbated by profit-taking on curve steepening positions: the 2-10 year spread reached a record earlier last week.

Third, the market is not a perfect seer. Exhibit 3 shows the forecast error on the six-month-ahead Fed funds target (that is, the gap between the funds rate priced in six months beforehand compared to the actual target rate). To be fair, short-rate markets are worse at forecasting easing cycles than tightening cycles. (I haven't adjusted for carry costs, so I'm being marginally harsh, but the errors are so large that that adjustment wouldn't significantly change the picture.) The error in the last cycle was fairly small - no doubt due to the Fed's clear signaling of imminent change. In prior cycles, however, short-rate futures got too hawkish, too soon.

Fourth, regardless of whether the market is right or wrong, it's clear that uncertainty is rising. Jim Caron has noted that the effect of the non-conventional policy measures was to limit the range of rate outcomes, therefore damping volatility. As those measures are relaxed, volatility will increase. This is now happening in the rates space. Exhibit 4 shows the sharp rise in the Move index, which is the Treasury counterpart to the Vix index. (For more details, see Jim Caron, Bonds: A Bursting Bubble? June 2.)

Fifth, while other developed-economy rates are correlated with US rates, the rise has been much less pronounced. Our European rates team thinks the market is right to price in the end of easing - but does not think that tightening is imminent. See Laurence Mutkin, End of Easing: Implications, June 5.

Finally, for equity investors, the rise in Treasury yields combined with expectations of tighter Fed policy bring to an end the uber-sweet spot enjoyed over the past three months: less bad macro data, a reversal of extreme positioning, low rates, and the expectation that policy would remain ultra-accommodative. Equities usually do cope well through the early stage of a tightening cycle: both policy-makers and equity markets are responding to the burgeoning economic recovery.

But this is not a normal cycle. Markets have run hard and are now, by my reckoning, increasingly priced for a sharp macro and profit recovery. Such a recovery still seems unlikely, at least within developed economies. The change in the rate environment may not singlehandedly stall the rally in equities, but in my view it is another indication that the risk-reward on equities is again tipping. I've nominated 950-1000 SPX as a likely region for the rally to peter out, with a stretch target of 1100. With rate markets now starting to shift, this still seems a reasonable upper bound for how far the current rally will travel.

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