It has been an incredible recovery on indices in the past few weeks. Markets have rallied strongly as the negative shock of the breakout of war in Europe has been absorbed. However, as the war continues, bond yields are spiking ever higher in fear of inflation and the ever more aggressive tightening of monetary policy. The recovery on equity markets is coming amid some significant warning signs flashing for financial markets.
- The flattening Treasury yield curve is seen as a warning signal for an impending recession
- Indices are recovering towards crucial resistance levels
Bond markets are flashing red warning lights
The adage in financial markets is that bond markets rarely get it wrong. There have been some sharp selling of bonds in the past few months, but this sell-off has accelerated since the war kicked off in Ukraine.
The spread between longer-dated yields and shorted dated yields has plummeted and is now closing in on zero.
This matters because when the spread hits zero, it is a red warning light for the economy. Higher short-term interest rates (represented by the 2 year Treasury yield) come with a need to have lower interest rates in the future because of the hit to the economy. To cut a long story short, it shows that bond investors are willing to buy longer-dated bonds for a lower yield because they believe that the Fed has gone too far and will need to cut rates eventually to save the economy from recession.
The chart below from the FT shows that every time the spread has hit zero, the result has been a recession in the US. This averages around 18 months later.
We can see on the yield curve (which shows the percentages of bond yields across the range of durations) has already become inverted from 3 years (2.37% today) to 10 years (2.35% today). The shorter end of the curve (c. 2 years) has been the key mover. Following on from Fed chair Powell’s hawkish speech yesterday, there is an expectation that this could push short-term rates towards 2.5% maybe even 2.75%.
This should be negative for equity indices
So why does this matter for equity markets? If bond markets lead the way and bond investors to believe that a policy mistake is coming (too high rates chokes off economic activity), then this is negative for equity markets. Falling economic growth (and potentially negative growth) tends to drive corrective pressure.
The issue is that the yield spreads are at their lowest since 2019/2020, around the pandemic time. However, for the pandemic, there was a massive monetary easing and fiscal support of trillions of dollars. This time, there will not be that happening. Equity markets are on their own. Bond markets are certainly a warning for the equities rally.
The counter to all of this doom and gloom is that the 3 month/10year spread is widening. This is the spread that has been seen by the Federal Reserve and is more predictive of recession. However, the warning signs elsewhere will be enough to get investors thinking.
Technicals are positive on equities for the recovery
Despite all this though, for now, equity markets continue to build their recovery from the sell-off in response to the breakout from the war in Ukraine. There has been an improving picture of base patterns and recovery trends in place for major indices. However, we will point out that there are crucial resistance levels overhead that need to be broken. If not, these moves still have the risk of bear market rallies being formed.
For S&P 500 futures (MT5 code: SP500ft) there has been a break above 4418 which was the early March lower high. This has now completed a 280 tick base pattern which implies a move towards 4700. The crucial level of resistance is the key lower February highs at 4585. These need to be broken for the recovery to continue. They will be a source of overhead supply and a worry for the continued recovery.
For European indices, the German DAX (MT5 code: GER40) was smashed in the wake of the breakout of the war. The recovery has been impressive and recently formed its base pattern on a move above 14,120. This neckline has also become supportive.
However, the medium-term outlook is less secure for the DAX, with the crucial resistance of overhead supply between 14,800/15,000. This also coincides with the 11-week downtrend resistance (currently around 14,900). This leaves a crucial barrier yet to be overcome, something needed to suggest this move is anything more than a bear market rally.
Finally, we see the FTSE 100 (MT5 code: UK100), which is seen as the most secure for recovery. Technically the market has rallied through crucial resistance at 7264 (which is now a basis of support) and held a recovery uptrend. FTSE 100 index is packed with resources stocks taking advantage of the gains in commodity prices) and has a big weighting in value stocks (which perform better during times of higher yields).
The technical recovery is so well developed, that the market is now eyeing a test of the resistance band between 7490/7565 which is protecting the multi-year high of 7695.
So, for indices, the key question is whether this recovery can continue in the face of the ever flattening US yield curve? For now, everything looks OK from a technical perspective, but there are still some crucial resistance levels overhead that could have a big say in the next medium-term direction.