Will the Fed blink?

Stocks rallied on Friday capping off a week of growth for the indexes despite weaker than expected showings from big tech. The Fed favorite inflation figure came in slightly lower than expected and stocks applauded.

That was great, now what? Who doesn’t like a rally in stocks? Especially given the performance of the indexes over the past year. Lots of ups, but more downs, leaving investors with painful losses. So, when the Dow Jones Industrials rallied +828 points on Friday chock-full of complicated economic numbers, on the heels of what was once a top 10 S&P500 tech darling (META) making a big mess in its bed (PG13 version), well… we take notice. It’s nice to have a whole weekend to contemplate the possibility that we might actually be able to retire on our savings before we turn 99.

Inflation ticked higher according to the latest PCE Deflator, and consumers are more confident than expected according to Friday’s University of Michigan Sentiment. Could the Fed turn dovish on news like that? Let’s widen our view and see if we can come up with a good reason for the unbridled elation in equities. Starting with bond yields, they have been quite volatile across the entire yield curve. That has been the norm over the past 18 months, but completely uncharacteristic over the longer term… on average. The Fed is raising interest rates, which I am sure you heard about. It is not just raising them gingerly, but rather, it is frantically raising interest rates. Further, the Fed is selling bonds, which reduces the money supply. Decreased supply means money costs more… well, money, if you want to borrow it. That is another factor pushing interest rates higher. Well, that is the intention of the Fed – make consumption more difficult with hopes that decreased demand will slow down inflation. Is it working? Well, on the surface, it certainly doesn't appear that way. Yes, the Core PCE Deflator still ticked higher last month according to Friday’s release, although it was slightly less than expected. I have said that, at a high level the Fed will only stop raising rates if inflation meaningfully trends lower, the economy cracks into a recession, or some sort of financial mistake occurs. Inflation has not ticked down meaningfully, and a financial mistake does not seem imminent (based on the recent earnings releases from the banking sector). What about the economy?

Last week’s GDP number showed that the economy grew last quarter after shrinking for the prior half-year, indicating that the economy is not in a free fall and possibly not in a recession, despite its 2 declining quarters. So, on the surface, things look good for the economy. Does that mean that inflation will not go away and that the Fed will just continue to apply more and more pressure on the capital markets? Let’s broaden our view even further. The Fed does not want to ride the US economy into a recession. Members would clearly like to be remembered as the Fed that pulled off, a so-called, soft landing. To do this would mean pushing the economy to the brink of contraction and then rapidly lifting its foot off the break. An analogy would be an airplane diving toward the ground and pulling up last minute, just in time to avoid slamming into the earth. The pilot would have to watch the airplane’s speed and altitude closely and time a hard pullback on the yolk and then gun the throttle just perfectly. So, the GDP gauge and inflation gauge still show that there is further room to dive, but there are some other gauges that may concern the pilots of our economy. The yield curve is one of them. I have talked a lot about how an inverted yield curve has typically been a precursor to recession. I have been referring to the difference in yield between the 2-year Treasury Note and the 10-year Treasury note. That has been negative, quite negative, for some time. This alone would be alarming to the Fed. Last week however, an even more disturbing alarm came from the yield curve when the yield on the 3-month Treasury Bills exceeded the yield on the 10-year Treasury Note. That is yet another warning that the ground is coming up fast. As of today, the futures markets have factored in a +75 basis-point rate hike later this week. Though that has a good chance of occurring, the Fed will certainly be paying attention to those gauges just mentioned. Last week, the Bank of Canada surprised markets with a lower-than-expected +50 basis point hike along some pivot-like words. Perhaps the Canadian bankers feel like the ground is approaching fast. If, indeed, the Fed is watching those indicators mentioned above and it follows up with similar language to the Bank of Canada, last Friday’s rally may stick. The ground is rapidly approaching, and we will have to see what our pilots will do on Wednesday. For now, keep your lap belts tight and stay in the emergency landing position to minimize injury.

FRIDAY’S MARKETS

Stocks rallied on Friday after an inflation figure came in weaker, slightly weaker, than expected. The S&P500 gained +2.46%, the Dow Jones Industrial Average climbed by +2.59%, the Nasdaq Composite Index jumped by +2.87%, and the Russell 2000 Index advanced by +2.25%. Bonds slipped and 10-year Treasury Note yields added 9 basis points to 4.01%. Cryptos added +0.09% and Bitcoin advanced by +1.16%.

NEXT UP

• MNI Chicago PMI (Oct) may have increased to 47.0 from 45.7.
• Dallas Fed Manufacturing Activity (Oct) is expected to come in at -18.5 after printing -17.2 in September.
• Earnings after the closing bell: Vornado Realty Trust, Avis Budget Group, Trex, SBA Communications, American Water Works, William Cos, Good Tire & Rubber, and Regal Rexnord.
• Later this week: Lots more earnings in addition to JOLTS Job Openings, ISM Manufacturing / Services, S&P Global PMIs, Factory Orders, Durable Goods Orders, monthly employment numbers, and the FOMC meeting. Please refer to the attached economic and earnings calendars for times and details.