Image 1: Citi Economic Surprise Index vs. generic front month 2-Year Treasury Note futures

Image 1: Citi Economic Surprise Index vs.  generic front month 2-Year Treasury Note futures
Source: Bloomberg

The market is coming off a two-week period in which it has had to digest an awful lot of economic data: durable goods, 1Q GDP, new home sales, factory orders, ISM and, of course, non-farm payrolls. Not to mention, amidst all this data, the market also had an FOMC meeting to digest. I have always found it useful during the onslaught of data to refer to the Citi Economic Surprise Index. After all, it isn’t so much the absolute measure of the data. It comes down to whether the data is better or worse than expectations. The Citi index measures exactly that and is a mean-reverting index as a result. Looking at the index in white in the chart above, we can see that since early April, the data has come in considerably worse than expected.

Until very recently, however, the short-term interest market hadn’t flinched. Even going into the FOMC meeting on May 1, there was still some concern that the FOMC may hike rates this year, as evidenced by a question posed to Fed Chair Jerome Powell at the press conference. Chair Powell put that notion to rest, and with a weak data point in the non-farm payroll data days after, is beginning to focus on the weakness of data and what this means for short-term rates.

The 2-year yield is an accumulation for what the bond market thinks of Fed actions over the next two years. You can see that when I plot the futures contract inverted (giving me the yield), the time series of each plots very well versus the other until very recently. The implication here may be that the economic data is telling the market that short-term rates need to come lower in the near future because high rates could be impacting the economy. 


Image 2: Generic front month 2-year Treasury Note futures vs. the Russell 2000 forward Price/Earnings ratio

Image 2: Generic front month 2-year Treasury Note futures vs. the Russell 2000 forward Price/Earnings ratio
Source: Bloomberg

Equity markets and short-term rates markets are tied at the hip because the risk-free interest rate is the beginning of the process for determining a company’s cost of capital. If I aggregate this up to a market measure, there is a link between risk-free rates and the Price to Earnings multiple an investor should be willing to pay for the market. The higher the cost of capital, the lower the P/E one should be willing to pay. The lower the cost of capital, however, the higher the P/E one would be willing to put on the market.

In this chart, I have plotted the 2-Year Note futures vs. the forward P/E for the E-mini Russell 2000 small-cap futures. As 2-Year Notes go higher, the risk-free yield is falling. As the risk-free yield falls, investors should be willing to pay a higher P/E. If we look at this over the last couple of years, we can see that the intuition matches the result. If then, the 2-Year yields may be falling as the market digests worse-than-expected economic data, this could prove to be a benefit to the P/E for the market, with equities rallying in a ‘bad-news-is-good-news’ type of fashion. 


Image 3: Generic front month E-mini Russell 2000 futures with the 50-day and 200-day moving average

Image 3: Generic front month E-mini Russell 2000 futures with the 50-day and 200-day moving average
Source: QuikStrike

Image 4: Volume and open interest for E-mini Russell 2000 futures


Image 5: Open interest heat map for the options on E-mini Russell 2000 futures


Image 6: Open interest and put-call ratio for E-mini Russell 2000 options


Image 7: Implied volatility skew for June expiration E-mini Russell 2000 options


Image 8: Expected return for a short RTOM4 1950 put vs. long three RTOM4 2250 calls