Early Warning Signs: Keep calm, watch VP Correction Signal / bear steepening for warning signs

Relative to history, many asset classes have lower embedded risk premia today, even while the macro backdrop remains good. We essentially have a “valuation” problem in many assets, but not necessarily a “macro” problem.

We reconcile this tension by being explicit in using two early warning signs to indicate when high valuation assets are vulnerable: A) the VP Correction Signal (link) and B) any signs of bear steepening, especially in response to further Fed cuts.

The VP Correction Signal tracks when various credit spreads and cross-asset volatility are deteriorating at the same time. The key is not the magnitude, but the breadth of deterioration. The top two charts show a selection of the inputs. If implied volatility rises across all asset classes, alongside widening spreads, that would be a signpost of broad de-risking behavior, necessitating portfolio hedges.

The SOFR curve is also now struggling to discount a lower terminal policy rate, with the Dec 2026-2027 and Dec 2027-2028 parts of the curve still pricing hikes. The risk is that the Trump-inspired Fed tries to cut even more than the curve is pricing, driving a bear-steepening and questions about the Fed’s credibility. We are not there yet, but that’s what we are watching.