Stocks, like Michael Corleone in the Godfather, pulled back into bond market chaos

With a surge in Treasury yields ending Wall Street's best rally in two years, stocks are set to fall back into the clutches of the bond market over the final weeks of the year.

Nov 10, 2023 - 19:30

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Stocks, like Michael Corleone in the Godfather, pulled back into bond market chaos

An aging Michael Corleone, in the third edition of the Godfather saga, vented the loss of his hard-won empire, and the guilt tied to the murders he had to commit while building it, in one of the trilogy's most iconic scenes.

"Just when I thought I was out .... they pull me back in!"

Stock investors, having painstakingly constructed the longest rally on Wall Street in two years powered by a sharp pullback in Treasury yields, only to see it snuffed-out by yet another tantrum from the bond market, are likely suffering from similar (although perhaps not as existential) angst this morning.

Just when stocks thought they'd escaped the clutches of the Treasury market, and could count on gains powered by earnings prospects and value propositions, they get pulled back into the morass of Fed rate policy, Treasury refunding challenges and the day-to-day whims of the world's biggest financial market.

The warning signs were there, of course, and investors were told that a pivotal series of Treasury auctions this week could challenge the market's 'peak rate' consensus, but few were expecting the one-two punch stocks had to endure yesterday, in the form of a horrid 30-year bond auction and a lecturing message from a hawkish Fed Chairman.

Jerome Powell, speaking at an IMF-arranged event in Washington, appeared like a disappointed parent descending the stairs into a basement full of partying teenagers, insisting they turn down the music and put away whatever they're drinking in those red plastic cups.

Inflation hasn't been tamed, Powell said, and in fact markets have been tricked into believing that subdued CPI readings will lead to further easing of price pressures.

Because of that, he said, the Fed might have to raise rates again, and wouldn't hesitate to do so, irrespective of the market's overall complacency.

"Powell issued a warning to investors too giddy on the prospect of rate cuts next year, adding that the Fed will be true to its mandate and hike further should inflation reaccelerate," said Jeffrey Roach, chief economist for LPL Financial in Charlotte, North Carolina.

"The main reason markets are jittery is the Chairman warned investors not to be misled by the 'head fakes' of a few good months of data," he added.

Powell's seizing of the punch bowl, just as stocks were looking to test the longest rally on Wall Street since 1995, came less than an hour after investors watched the disintegration of the Treasury's $24 billion auction of new 30-year bonds.

The sale, the third of three newly beefed-up auctions under the Treasury's new borrowing mandate, drew muted interest from both foreign and domestic investors, forcing the government to offer a sharply higher yield in compensation and dealers to hold onto a staggering 24.7% of the total offering.

That sets up stocks for its new fourth quarter landscape: another possible rate hike, tighter financial conditions in the form of higher Treasury bond yields (which impact everything from corporate borrowing to mortgage rates), a deteriorating S&P 500 earnings forecast and a slowing global economy.

The crazy #volatility in US Treasuries continued today with a 15 basis point move up in yields for the 7-, 10-, 20- and 30-year #bonds (table below).
Per Bloomberg reporting from earlier (also below), this type of volatility is problematic for the functioning of a broad range of… pic.twitter.com/cdK1KxIWtq— Mohamed A. El-Erian (@elerianm) November 9, 2023

Collective S&P 500 profits, which likely grew 5.7% over the third quarter to a share weighted $483.6 billion, are expected to come in at around $465 billion for the three months ending in December.

Crude oil prices, a good benchmark for global growth, rare are down for a third consecutive week and hovering near the lowest levels since July, even amid the ongoing conflict between Israel and Hamas, which is threatening to draw in Iran and extended production cuts from OPEC allies Russia and Saudi Arabia.

Meanwhile, another government shutdown-showdown looms into next week as House Speaker Mike Johnson, the Republican lawmaker who emerged from the party's tax-and-spend squabble last month, faces a similar task that his predecessor failed to overcome.

That's not the greatest of news when the Treasury, which also saw limp demand for its $40 billion 10-year auction earlier this week, is attempting to entice foreign buyers – including China – to kick-in some of the costs linked to government's projected $2 trillion deficit.

Bank of America's closely-tracked "Flow Show" reports suggests all of those concerns are piling up: around $77 billion found its way into cash fund this week, putting it on pace for a record $1.4 trillion in new inflows this year, compared to $11.2 billion for bond funds and just $8.8 billion for stocks.

The bond inflow was the largest in four months, but mostly concentrated in longer maturities, suggesting that, at least prior to Powell's finger-wagging, investors were comfortable with peak-rate bets.

Next week's slate of releases, from inflation to retail sales, may go a long way towards confirming that thesis, or discarding it completely.

The Commerce Department will publish October inflation data Tuesday, with economists looking for the headline rate to hold at 4.1%, Retail sales figures follow Wednesday, with analysts looking for a modest pullback in October spending amid a decline in gas prices and run-down in post-pandemic savings.

Super-retailers Home Depot HD, Target TGT and Walmart WMT will also publish third quarter earnings, as well as critical holiday season outlooks, starting on Tuesday.

That sets up markets for a crucial end-of-year run, with gains powered either by promising consumer spending and 'soft landing' hopes or a pullback triggered by renewed inflation risks and a grumpy bond market.

As Hyman Roth noted in the second edition of the Godfather: "This is the business we've chosen".