A risk-on bounce after a ferocious correction; will it sustain?

The global bond market is down (US 10-year yield at 2.90% vs 2.80%), so is VIX (26/35), and dollar index (DXY) at 103.4/104.3 has come off the peaks seen in 22 years. This has triggered a risk-on rally today following a ferocious correction of 10-15% during Apr-May.

Indian benchmarks rallied by 2.6% ?(May 17th) but were outperformed by deep cyclicals like metals (6.9%), capital goods (3%), and small caps (2.9%). Even IT rallied 2.8% higher. Reality, Autos, Media had their turns last week. Broadly, all those that fell very sharply (25-40%) also saw a high level of rebound, but are still much lower than the early April peaks.

Globally also, markets that saw maximum meltdown earlier are also the ones that have seen the largest rebound (Russia, Sri Lanka, China, Nasdaq, US Small Cap, Austria, Vietnam, etc.). But they are still deeply negative on YTD performance.

Does this reemergence of risk-on, following a couple of weeks of risk-off, negate all those?macro factors such as hyperinflation, narrowing global liquidity, strong dollar, and rising rates? Or are they still alive?

One important development last week and today has been the toning down of the strident hawkishness by FOMC voting member James Bullard, who earlier also favoured 75bps hikes by the US Fed. His current stand is that 50bps hikes are enough, and with markets pricing in almost 3.25-3.5% Fed rate at the peak over the next 24 months, they have priced in all the normalisation. And like US Fed Chairman Jerome Powell, Bullard also reiterated that the US economy is fairly strong and will avoid a recession.

Our guess is that it is a catch-22 situation and the US Fed is trying to make a case for a soft landing amid the risk of a disproportionately larger negative wealth effect from the monetary transmission process, which is still far from the eventual effect of inflation control.

Such communication may be necessary to avoid a potential disruptive adjustment process, which has just begun. But Bullard's pushback to the general impression that the Fed is much behind the curve does not bear much credence given that inflation is still expected to remain high at 3% if one considers that after 2 years a neutral real rate 0.5% will be achieved.

Secondly, it is premature to assume that markets have priced in all the implications of normalisation just by looking at the rate swap curves, as the transmission process has to involve adjustments through a whole host of financial assets, including credit risk, illiquidity risk, solvency risks of financial institutions, etc., apart from just the bond, money and equity markets. While these markers have seen some reciprocation, there is still considerable underpricing across multiple markets.

Thirdly, such blow-hot-blow-cold?communications on normalisation may dilute the efficacy of monetary tightening if the markets absorb that to signal bottoming out of the commodity prices; for instance, the risk-on has seen Brent crude reclaiming USD 114.5/bbl. We saw a similar response when Powell communicated a dovish QE tapering in Sep'21, and ignored rising inflation. Thus, a comfy Fed statement ironically works toward compelling a more aggressive response later.

Overall, the current risk-on bounce may be shortlived in our view as a) it will take a long time to attain an above-neutral real rate of +0.5% for the US, b) the full scale impact of monetary tightening is not fully priced in, and c) the blow-hot-blow-cold communication on the tightening trajectory may complicate the inflation control efforts of the Fed.

Hence, we would like to consider the latest risk-on bounce as a part of a longer journey toward another capitulation, which is still a few laps away.