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  • US equity markets tanked on Thursday amid a massive surge higher in US bond yields.
  • Fed officials have thus far refrained from expressing concern about the bond yield rally, will their resolve be tested?

It was an ugly day on Wall Street. Just like that, the last two days of hard-fought gains (that had seen the S&P 500 even manage to recover back into positive territory on the week above 3920 from Tuesday lows just above 3800) have been wiped out.

The S&P 500 dropped nearly 100 points on Thursday to 3829, a 2.34% decline. The Nasdaq 100 index saw even steeper losses, dropping 3.56% just above the 12,800 mark. Meanwhile, the Dow lost 1.75% and the Russell 2000 finished 3.69% lower. The CBOE Volatility Index (also called the VIX) rose 7.55 to end the session at 28.89, its highest since 1 February.

Sectoral performance had an unsurprising defensive bias, with utilities holding up the best (but still finishing 0.98% lower) and consumer discretionary and information technology performing the worst (dropping 3.61% and 3.53% respectively).

Surging government borrowing costs

Surging US government borrowing costs were the main driver of equity market downside on Thursday. The bond market sell-off, which is pretty much all market participants have been talking about, saw the US 5 and 7-year bond yields surge as much as 20bps at highs and the 10-year yield surge nearly 15bps (to above 1.50%) at highs. Real yields have also been on the move; the 10-year TIPS yield has rocketed to fresh eight-month highs and is now close to the -0.6% mark, an incredible rally given that the bond started the day with a yield of under -0.8%. Needless to say, this is the biggest move in real yields since the Covid-19 pandemic induced market panic back in Q1 2020.

The S&P 500 value index, which contains stocks that are comparatively less exposed to rising long-term borrowing costs, ended the session down 1.89% lower. More heavily exposed growth and momentum names ended the session 2.96% lower. But none escaped the cascade; the US 10-year yield surpassing the average dividend yield of an S&P 500 company (1.48%) seemed to be taken as an equity market-wide sell signal.

What is driving the move higher in yields?

Well, though Fed officials have been dovish in their reassurances to markets that they will not be tightening policy anytime soon, given the bank is still a long way from its policy goals, Fed officials have not signalled any concern about upside in bond yields. This seems to have been taken as a “green light” for further upside. Meanwhile, decent US data (Weekly Jobless Claims, Durable Goods Orders and GDP), month-end flows and systematic trend-following algorithm selling are also being cited as pushing yields higher, as well as a very bad US 7-year bond auction which showed low investor appetite for new US government debt.

Yields are surging… What next?

Market participants have two questions on their minds as they leave their desks on Thursday; 1) how much further can this bond market sell-off run? and 2) how long until the Fed changes its tune and what might then do to cap yields?

The first is pretty much impossible to answer at this stage as the sell-off seems very much driven by market psychology rather than fundamentals (i.e. panic selling, capitulation and stop losses being triggered). Some market commentators have pointed out that if January Core PCE inflation (the Fed’s favoured inflation gauge) comes in hotter than expected then that could be the catalyst for a further leg higher in bond yields. If that does happen, expect more bond yield upside and most likely more equity market downside.

The second question is another one that one can only speculate about, but one trigger point for Fed action might be if the stock market sell-off really starts to get ugly, i.e. a 10% or more drop. As the central bank has shown time and time again in the past, when the stock market really starts to tank, they can and will be bullied into action.

In terms of what they might do, some Fed members are already talking about the potential for the Fed to adjust the weighted average maturity of its bond-buying programme towards longer-term bonds (called a “twist”). Such a move might take the steam out of further longer-term bond yield upside, but might not be seen as “enough” by equity investors.

Alternatively, the Fed could announce yield curve control, i.e. capping bond yields at a certain level by pledging to buy bond in unlimited amounts to keep yields there. The only problem with this is that if it is inflation expectations that are driving yields higher, more QE in potential unlimited size will further increase the money supply and further boost inflation expectations and upside pressure on yields (some have compared the YCC policy to fighting a fire with petrol). More simply, the Fed could just announce an expansion of its monthly asset purchases, which are currently $120B per month ($80B of which are treasuries).

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