Bear Market Rally Takes Hold

Major stock market averages surged at the open, continuing the week-long rally. At the moment, the Dow is up 650 points and the S&P 500 is up 2.4%. The hard-hit Nasdaq is also up 2.4%. A number of market sectors are up 3% or more in early trading: financials, industrials, communications and materials. The VIX fear gauge fell back to 27.2 and gold is flat. Both copper and crude oil are bouncing higher. The bond market is taking a rather risk-on stance this morning, with junk bonds rallying but safe-haven Treasuries selling off. What we’re seeing, then, is a relief rally in both bonds and stocks, which have already priced-in a lot of risk in a very short period of time.

We’re witnessing something of a tug-o-war between the high inflation/rising interest rates regime and the recession/falling interest rates regime. This is especially true in the bond market. When the Federal Reserve laid out its battle plan to tighten financial conditions and fight inflation the bond market very quickly priced in all the expected rate hikes for 2022. After the Fed’s last meeting the 2-year Treasury Note yield climbed to 3.4%, the highest since late 2007. But at some point, while sharply higher interest rates will certainly kill inflation, they also could end up pushing the economy into recession. For example, higher mortgage rates seem to have had an immediate impact on existing home sales. And as investors become more convinced that economic growth is slowing and recession risks are elevated, interest rates should begin falling. Indeed, over the past week the 2-year yield has fallen to 3.04% from 3.43%. In other words, bond traders seem to be increasingly convinced that the Fed’s policy is working, and they won’t have to go through with all the planned rate hikes. That, of course, is the cornerstone of the hoped-for “soft landing” scenario: rate hikes bring down demand and inflation to more normal levels without breaking the economy.

June’s final reading for the University of Michigan’s Consumer Sentiment Index was a bit less dire than initially reported. Consumer sentiment edged slightly lower to a record low. But inflation expectations eased. Survey respondents expect inflation to run at 5.3% over the next year, then settle down to an average of 3.1% over the next 5-10 years. About half of survey respondents expressed “bleak views about the risks of recession or unemployment.”

In recent days we’ve heard a number of economists wonder whether we are talking ourselves into recession. That is, widespread worry and lack of confidence in the immediate future could cause consumers to sharply slow spending and increase savings. But this morning, Federal Reserve official James Bullard said he believes the fear is overdone. “I actually think we will be fine.” In his view, “this is in the early stages of the US recovery” from the 2020 Covid recession. “It would be unusual to go back into recession at this stage.” Noting that US households are in good financial shape and unemployment is extremely low, he believes the economy can withstand Fed interest rate hikes.