Inflation and The Fed still take top billing

Stocks closed slightly higher yesterday, well off intraday highs, as China gave signs that its strict lockdowns may soon ease. Bond yields jumped and both stock and bond investors were left wondering.

Just like clockwork. It has been a tumultuous year for stock…and bond investors. Small moves up and down seem like a relic from some past era, long forgotten. You can glance at a television and see the Dow up materially, smile to yourself (maybe even utter a prayer), and make a phone call or fix yourself a cup of coffee, only to glance back at the screen to see a red number screaming at you…hopes lost and maybe another, slightly different prayer. We know by now what the reason is for the volatility, but that certainly doesn’t make it easier to deal with. Inflation is obviously the root cause of all the praying. It is unquestionably high…and sticky, so the next question is when will it moderate. It can end on its own, as many speculate, or it can end at the hands of the Fed… or both. Ending on its own would be the most favored scenario while any scenario that involves the Fed and interest rates is, let’s just say… unfavored, and the reality is, we just don’t know yet, so any hints in one way or another evoke extreme elation or fear…ending in volatility. However, beneath the surface volatility, there is actually some order.

Shorter maturity bond yields attempt to determine where Fed Funds will be in the future, and as such are closely tied to Fed policy and guidance. The 2-year Treasury Note now stands at a yield of 2.71%, which is somewhat consistent with the Fed’s longer-term projection. More importantly, it is +21 basis points higher than the neutral rate (r-star) which many economists and FOMC members believe to be the rate at which policy is neither helping nor slowing down the economy. In other words, a 2.71% Fed Funds rate would be slightly dragging on the economy. What is somewhat striking is the fact that 2-year Note yields were right around 2.5% at the end of May. That’s right, yields gained by some +17 basis points far this month through yesterday’s close…4 trading days. I am not sure you know, but a move of that magnitude is quite large for a 2-year maturity…now you know. Recent economic data suggesting a strong economy is likely to blame. A strong economy means that consumers are likely to go on spending and keeping inflation high. It also implies that the Fed may feel that it has more room with rate hikes. Let’s zoom out for a little perspective. The 2-year has been trading around 2.50% since early April and reached a peak of 2.64% in early May before receding into the month end, and this latest move, while it seems large, is still within its recent trading range.

Moving out to longer maturity Treasuries, the 10-Year note closed with a yield above 3% yesterday for the first in 17 sessions. The 10-year Note trades more at the mercy of the markets. Its yield climbs when traders expect inflation and potential bumps in the economy. Yield on the 10-year closed above 3% in early May for the first time since 2018, but ultimately closed out the month at 2.84%. Yesterday’s breaching of 3% could be a reflection that investors are concerned about persistent inflation, once again. Yesterday morning, news that COVID rates in China were beginning to moderate and that authorities were easing restrictions drew initial applause from equities. Increased Chinese demand for price-sensitive commodities may point to more inflationary pressure. That was certainly a contributing factor to rising bond yields across the curve. There was also something else, a glimpse back at those days of yore, which I referred to at the head of this piece. Remember when stocks went up and bonds went down…and vice versa? It’s true, in a time which seems long ago, stocks and bonds traded inversely. There are lots of technical reasons for it, but, for the most part, when investors are fearful and sell equities, they typically seek shelter in bonds, considered a less risky asset. When the fear abates and investors look to buy stocks, they must first sell their safe-haven treasuries – bonds would fall as stocks would climb. We got a little glimpse of that former era yesterday. It was somewhat comforting, however fleeting. Don’t worry, we will get back to it. When, however, remains the big mystery.

YESTERDAY’S MARKETS

Stocks got off to a strong start yesterday morning on encouraging new from China, but the rally ultimately lost steam as inflation fears, and higher yields caused selling. The S&P500 rose by +0.31%, the Dow Jones Industrial Average climbed by a scant +0.05%, the Nasdaq Composite Index traded higher by +0.40%, and the Russell 2000 Index advanced by +0.36%. Bonds dropped and 10-year Treasury Note yields climbed by +10 basis points to 3.03%. Cryptos gained +6.61% and Bitcoin advanced by +5.06%.

NXT UP

• Trade Balance (April) is expected to come in at -$89.5 billion after registering a -$109 billion deficit in the prior month.
• The Treasury will auction off $44 billion 3-year note yields today. Participation will be closely watched to gauge the sentiment of traders.