BMO: Optimism Is Getting Ahead Of Itself And Equities Are Vulnerable To Disappointment As Economy Reopens

Authored by Ian Lyngen, Jon Hill and Benjamin Jeffery, rates strategists at BMO Capital Markets

In a continuation of the recent trend, risk assets have extracted sufficient optimism from the reopening preparation to further recoup much of March’s losses. S&P 500 futures touched 2905 overnight and appear poised for another strong open despite the recent turmoil in the energy sector and a widely anticipated negative Q1 GDP print on Wednesday. The divergence between domestic equities and other financial markets has become the hallmark of the current financial crisis; so much so that we find ourselves wary of a capitulation of the bears which would add future upside impetus. Just how linked risk asset performance is to the realities of a post-pandemic world remains to be seen; although we’re sympathetic to the notion that global central banking largess will result in limiting the downside for the labor force while still struggling to create demand-side consumer price inflation (or prevent downward pressure).

This leaves the cynical among us to highlight the pre-crisis attempts at stoking inflation as the archetype for the coming years. Recall that in the absence of higher AHE/CPI, easy global monetary policy primarily drove more attractive valuations of equities, housing, and tighter credit spreads. The asset-price inflation narrative isn’t new in this macro environment, however as a potential driver of the divergence between stocks and bonds, it offers a compelling explanation. Said differently, while investors are skeptical of the Fed’s reflationary prowess, much more credence is given to policymakers’ ability to prop up risk assets.

We’re also open to the argument that the difficulty in judging the potential economic fallout from Covid-19 leaves investors with little else to trade except for incremental milestones. The next up being the staged reopening of the US economy. While there is a real risk the optimism is getting ahead of itself and equities are vulnerable to disappointment with the results of the reopening, for the time being it is a difficult trend to wholeheartedly fade. Instead, we’ll go-with the two enduring themes of consolidation in US rates and slow-and-steady improvement in risk.

A quick glance at the consensus for Q1 real GDP leads one to envision a somewhat counterintuitive scenario; a ~4% contraction of the domestic economy followed by the S&P 500 drifting >3000 on progress toward reopening. This would represent just -11.6% from the record highs and put stocks -7.2% year-to-date. The next several trading sessions hold the potential to exaggerate the ‘disconnect’ which continues to create a sense of collective unease with the way in which markets have responded to the pandemic. Habituation of grinding gains creates complacency; this speaks to the prospects for another downside correction in stocks should May see any signs of a resurgence of Covid-19 cases.

As the pre-FOMC session, today will largely function as a placeholder in the Treasury market with 65 bp the present equilibrium for 10-year yields. Breakevens continue to struggle to break 125 bp and given the repricing experienced in the energy complex our expectations are for more of the same. It’s encouraging to see the stabilization of the curve which has come to pass in the last several sessions. 2s/10s at 44 bp this morning leaves the benchmark curve at the upper-end of the range held throughout the latter half of April. Supply has had remarkably limited influence on the outright level of yields during the crisis and we don’t expect that will change anytime soon. The inability of Monday’s $190 bn front-end offerings to even incrementally flatten the curve is a new couture to the market’s supply indifference and it will be telling to see how far that extends as month-end comes into focus. The Treasury benchmark month-end need is 0.14-year and the largest since August 2016.