Last week saw a remarkable and extensive rally across asset classes, with oil being one of the few exceptions to experience a sell-off. Both stocks and bonds experienced moves in excess of two standard deviations, marking one of the most significant weekly asset class rallies in the past two decades. As a result, higher-frequency correlations between stocks and bonds (measured over two weeks) returned to positive levels after briefly reaching zero in October.
Since the summer, the “bad news is good news” trend has resumed for risk assets and duration. As recession fears faded, negative surprises in growth indicators, such as the weaker ISM and employment data from the previous week, led to a more dovish repricing of real interest rates, which benefited equities and bonds.
Bond markets experienced a flattening of the bull market, but the drivers varied by region. In the US, the rally was driven by lower long-term real rates, supported by a reduction in duration supply, cooling economic data and a reversal in short-duration positioning.
In Europe, negative inflation surprises contributed to a decline in market-implied inflation and short-term rates moved more than historical patterns would suggest. Sovereign spreads tightened on improved risk sentiment and lower core rates.
In Japan, bonds sold off as the Bank of Japan ended its fixed income purchases. The market is already pricing in a policy rate hike of around 9 basis points by the end of the first quarter. However, Japanese economists are coalescing around the idea that the BOJ will end negative rates in October 2024.
Overall, last week’s rally across asset classes eased financial conditions by about 50 basis points, according to Goldman Sachs models. As a result, the US Financial Conditions Index is back to where it was at the beginning of the year, despite 100 basis points of rate hikes since the beginning of the year.
As the Federal Reserve acknowledges the recent tightening in financial conditions, this reduces the need for future rate hikes, potentially increasing the risk of hawkish surprises and forcing markets to reassess the possibility of Fed rate cuts early next year.
Although market-implied probabilities of further hikes in 10-year OIS rates are still elevated (except in Japan), they have declined along with declining interest rate volatility. In terms of asset allocation, most observers, weeding out the usual bulls and bears, think the picture is very unclear; we are looking for neutral at year-end, with the expectation that as disinflation continues, equity-bond correlations will eventually become less positive, making bonds a better “risk-off” hedge in the event of significant downside growth surprises.