To dispel any lingering doubt, we cite several pieces of evidence. First, the assets that would be expected to rally on stronger US inflation did not; commodity prices, for example, fell and have now declined by more than the drop in US equities in February. Second, bond proxies in the US stock market should have underperformed; they did not. Third, fed funds futures would have moved to price in a greater likelihood of more fed hikes this year. They did the opposite, taking their cue from the equity move. Fourth, while VIX went from 13 to 37 between January 29 and February 5, rate vol (we use 1y*10y bp vol) barely budged in that period. It rose from 69 bp/y to 74 bp/y, far below the 90 bp/y it moved last year when 10-year yields rose just above 2.6%.
But even if the recent sell-off unfurled amid hedging and outright selling from volatility investors, the seed of the correction was the US employment report, which showed accelerating wage inflation. A stronger-than-expected US CPI print this week has strengthened this narrative.
We understand why investors are concerned. The US economy is growing well above trend, the unemployment rate is close to all-time lows, and we just passed fiscal stimulus through not only the tax cut but also via the recent budget deal. The case for a benign path for policy rates rests in no small part on well-behaved wage growth and inflation.
Is there a next ‘shoe to drop’? So far, most asset classes outside of US equities and volatility have been relatively well behaved. Recent moves in FX markets smack of risk-limit motivated reduction of longs, rather than more fundamentally driven risk aversion. Emerging market strategist Bruno Velloso points out that none of the conditions that typically foreshadow a sell-off in EM credit is present.
Instead, we recommend keeping an eye on the US high yield credit market, which is at risk from a dynamic that is somewhat analogous to what unraveled the US stock market. Specifically, about a fifth of the US high yield is owned by retail investors. Historically, sharply higher yields have led to outflows from high yield funds. At the kinds of low spread levels we are at today, these episodes have led to negative total returns, often with knock-on effects in other markets such as equities. There is some nascent evidence for this dynamic already: though US investment grade outperformed equities on a beta-adjusted basis, high yield underperformed. We do not think credit conditions have tightened enough to have a fundamental effect on high yield companies. But to the extent that broader corrections have often originated in this market, US high yield fund flows are worth watching.
For now, we believe that the technical correction in the markets over the past two weeks has likely run its course, while the inflation fundamentals simply suggest a slow grind higher, rather than an inflexion point towards much higher inflation and much tighter Fed policy.