Talk is not cheap

Stocks slipped on Friday as investors remembered that the Fed was keen on raising rates until inflation is abolished. Inconsistent economic data makes predicting the Fed’s next move tricky.

A tale of two opinions. Have you noticed that there have been dueling narratives recently? You don’t have to answer that question…it was a set up. Of course, there are two opposing narratives, that is how we get a market. Some investors want to buy, and some want to sell. When the desire to buy outweighs the combined desire to sell, stocks rally, and vice versa. Most of the time, one of those two is in clear control. The biggest challenges occur at junctures like these where there is no clear direction. In other words, when we are at an inflexion point, or more simply, at a crossroads.

Since the start of July, a hint of bullishness entered the equity markets. It is true that stocks were oversold in the lead up to Q3, particularly in growth stocks, which have been under pressure since late last year. Buyers typically jump in when quality stocks are severely oversold hoping to pick up longer-term buys at a discount. Who doesn’t like a sale? But there was something else that fueled the recent rally. A combination of subtle verbal hints and a run of weak economic numbers that led to the conclusion that the Fed would have to alter the path of its aggressive tightening for fear of sparking off a recession. That is a reasonable thesis given that the Fed has caused recessions in the past and that the central bankers are acutely focused on not repeating past policy errors. The result: a rally in stocks which are most sensitive to interest rates.

The bond market, on the other hand, has a completely different narrative. Check out the following chart of the 2-year / 10-year yield curve. That curve is typically positive, reflecting higher yields for longer maturities (referred to a term premium). That makes sense, right? If you loan money to the US Treasury for 10 years, you would expect to get a better return than a 2 year loan, considering that you are taking a longer term risk. In certain rare occasions that yield curve will invert. An inverted yield curve occurs when the Fed is aggressively tightening, and bond investors are expecting the economy to fall on hard times. Since 1955, an inverted yield curve has predated every recession!

So, we already know that we are in a technical recession. Many economists are highly focused on employment, industrial output, and consumer confidence, the latter two of which are weak. High unemployment is usually the single factor that makes a recession feel like a recession, so economists are correct in focusing on it. That said, employment is holding up rather well, based on the most recent, exhaustive monthly survey and last week’s weekly figures which improved for the first time in several weeks. Those positive developments should only embolden the Fed in its tightening endeavors, and Fed speakers have said as much. Last week’s parade of Fed speakers clearly fell on the side of hawkishness as most seemed determined to stay the course. Bearing in mind that the last time the yield curve inverted back in 2019 (see the chart above), the Fed was cutting rates in order to avoid a recession…and that was just a shallow inversion compared to the current one.

So, it is clear that the bond market is expecting a rough road and the Fed seems determined to ride that road. Stocks have disagreed since early August, but Friday’s decline is the first hint that perhaps, stock traders are rethinking their prevailing thesis. The debate rages on with no clear winners as yet.

FRIDAY’S MARKETS

Stocks fell on Friday as Fed hawk talk reminded stock traders that the Fed is determined, AT ALL COSTS perhaps, to fight inflation to the death. The S&P500 Index fell by -1.29%, the Dow Jones Industrial Average slid by -0.86%, the Nasdaq Composite Index dropped by -2.01%, and the Russell 2000 Index gave up -2.17%. Bonds fell and 10-year Treasury Note yields climbed by +8 basis points to 2.97%. Cryptos fell by -9.23% and Bitcoin dropped by -9.15%.

NXT UP

1. Chicago Fed National Activity Index (July) may have slipped by -0.25 after falling by -0.19 in June.
2. The week ahead: Retail earnings and more. Economic numbers come in full-force this week with housing numbers, PMIs, Durable Goods Orders, 2^nd Revision GDP, University of Michigan Sentiment, and the most important PCE Deflator, which is the Fed’s favorite inflation gauge. Also, this week, central bankers will meet in Jackson Hole to discuss policy and the week will end with a speech from the most powerful central banker in the world, Jerome Powell. Please refer to the attached calendars for times and details.