Authored by Hans Mikkelsen of BofAML,
Today’s market reaction to Fed chair Janet Yellen’s Humphrey Hawkins testimony – which was initially perceived as hawkish – provided another highlight of just how nervous investors have become about the risk of tighter monetary policy, post the very strong June payrolls report. Thus, as 10-year interest rates rose 4bps during the first hour after the release of the testimony, stocks declined about 0.4% (Figure 1).
Clearly weighing on stocks was also commentary in the Fed’s Monetary Policy Report that certain sectors – specifically smaller social media and biotech companies - appear richly valued in the market. However, these sectors account for a very small share of the market and the Fed argued that the general stock market is not trading far from historical norms. Today’s initial market reaction mirrored almost exactly the initial reaction on July 3rd to the June jobs report itself, as in the first seven minutes or so 10-year Treasury yields rose 5bps while stocks declined roughly 0.3% (Figure 2).
We argued that the current pace of jobs creation mirrors what forced the Fed’s hand in the 1994 rate hiking cycle, which led to lower stocks and wider credit spreads. This is not to suggest that we are forecasting a repeat of 1994 – only that we, as statisticians, have insufficient information yet to reject decisively that this is 994. Hence the initial reaction today when - after strong readings on Empire Manufacturing and Retail Sales –chair Yellen sounded more upbeat in her assessment of the economy and repeated that “If the labor market continues to improve more quickly than anticipated by the Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned”. Again, this scenario may not actually play out - but clearly the likelihood of such development increases with good economic data.
Again, we think this means that hedges should be set and long positions in risky assets reduced. We also think that this most likely explains the weak markets during the early part of last week, in a vacuum of little economic data, following the strong jobs report issued just before the Independence Day holiday weekend (Good news, flight to quality). For example declining stocks led by higher beta small caps, and widening credit spreads (Figure 3). With rallying Treasuries this indeed suggests rational risk reduction in reaction to the jobs report (Figure 4).
Apart from buying vol in credit we think that a particularly attractive hedge against interest rate risk in credit right now is the 10s/30s spread curve flattener.
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It's official - whether you believe the reality of the headline jobs data or not - the Fed does and will act and "good news is bad news" for risk assets according to BofA