A basing phase on Wall Street could be a long process

Market sentiment has been far more upbeat in the early moves of 2023. Plummeting energy costs have helped Europe to outperform Wall Street. However, more some positive signs point towards better performance in the months to come. Pricing for the interest rate tightening from the Federal Reserve is reaching its maturity and this should help to underpin Wall Street. It just might take some time for a sustainable recovery to take hold. 

• Wall Street remains tightly aligned to the prospects of real US bond yields. The negative correlations are key drivers of the broader outlook.
• For now, the negative long-term trends are holding on US indices, but ranging patterns are building

The rise in US “real” yields is plateauing

The sharp increase in US bond yields (more specifically “real” US bond yields) had a significant negative impact on Wall Street in 2022. However, in the final months of 2022, there was a shift in sentiment. Markets started to price for the “Fed pivot”, where the Federal Reserve would begin to ease off in its tightening of interest rates. Expectations of a “peak Fed” has set in.

In the wake of the tier-one US data on Friday there was a key move lower in US bond yields. The US Nonfarm Payrolls report and subsequent ISM Services PMI pointed towards growing signs of contraction in the US labour market and reducing inflation pressures. The 2-year Treasury yield (seen as a key indicator of US interest rates) fell sharply to break a 12-month uptrend. US bond yields seem to be plateauing. Reaction to 4.03%/4.26%, an important floor in the 2-year yield will be a key gauge in the coming months. 

Looking at the “real” US bond yields (US bond yields minus inflation), we also see this plateauing. The 10-year real yield has been ranging for several months now. The uptrend since March is possibly now also breaking.

If US Treasury yields do begin to move lower then we can expect this to drive real yields lower (as inflation expectations appear to be more subdued).

This is all significant for Wall Street. There is a strong negative correlation between real US yields and how US equity markets move. The S&P 500 futures have an average correlation of -0.43 over the past 12 months (i.e. strong). As real yields have plateaued we have seen S&P futures starting to look more positive.

There is an even stronger correlation between NASDAQ Composite and the real US bond yields, with an average correlation of -0.45 over 12 months. Since April, the correlation has been almost constantly negative.

So, how markets price for the Fed tightening will be key for whether a Wall Street rally can take hold in the coming weeks and months. The data seems to be pointing towards less inflation pressure and growing recession potential. The question is whether the Fed fights back on this narrative. 

Yesterday’s comments from two Fed members suggest that they are cautious about signalling the end of tightening. Fed Chair Powell speaks later today. It could be a theme in the coming weeks that the Fed consistently fights back on the data, for fear of easing policy too soon. This may help US bond yields to remain high. As we mentioned earlier that band of broadly 4% to 4.25% on the US 2-year yield could become an important gauge for markets.

It may take several weeks or even months for the Fed acknowledges a peak in rates and this might restrict the potential for a decisive Wall Street rally.

Technicals reflect a ranging outlook

Looking at the technical analysis, we still see the S&P 500 futures (SP500ft) in the 2022 downtrend phase as we have moved into 2023. However, the market looks to be in a consolidation over recent weeks. The pivot band 3912/3945 is key to this ranging market. Support is holding at 3788 and the bulls will be looking for a closing move above 3945 to open a serious test of the long downtrend again.

The NASDAQ 100 futures (NAS100ft) are less encouraging but do show that there is a multi-month range in play. The key support at 10485/10760 is holding firm, with the RSI increasingly reflecting a ranging outlook (between 35/60). Reaction around a mid-range pivot band 11390/11465 will define the near-term outlook.

For the Dow futures (DJ30ft) the outlook remains more positive. Having already broken the primary downtrend the market is using this as a basis of support now. There is a consolidation taking hold early in 2023, but the market is consistently testing the resistance above 34000. This is encouraging.

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