Stocks came up with another mixed close following a bumpy day of trade as traders scratched their heads wondering why Treasury yields were on the climb. Traders have fallen off the wagon and are once again gripped by their unhealthy addiction to the Fed dropping concern for the economy.
I want it now. What are you looking forward to next week? Halloween, perhaps? Not me; I can certainly do without raiding the family candy bowl that sits beside my front door on that day. No, you are looking forward to next week’s GDP release, of course. Everyone wants to know how the economy is doing, especially nowadays, and its not because folks are worried that things are bad. To be clear, many were concerned that the economy was starting to lose its breath going into last month's FOMC meeting. Based on the Fed’s policy decision, perhaps the Fed policymakers were concerned as well.
A -50 basis-point cut is big deal, after all. Based on recent history, the Fed likes to move in ¼ basis-point increments, so coming up with, what I coined at the time as a “two Oreos” cut is worth noting. And it was noticed. In the wake of the cut, traders switched their focus to worrying about the economy, dropping their obsession with rate cuts. Quite right. At the end of the day all companies suffer when the economy is struggling, and no one wants that.
Leading up to the monthly job numbers earlier this month, fear mounted as traders prepared to take pain if the numbers came in light. Employment is a critical driver of growth. I am sure I don't have to remind you that people who are worried about their jobs… um… tend to spend less money, and spending money is what drives economic growth. By 08:30:30 Wall Street Time on Friday, October 4th, all that fear disappeared when the Bureau of Labor Statistics announced that +254k new Nonfarm Payrolls were added in September when economists were expecting +135k. Amplifying that good news was a decline in the Unemployment Rate to 4.1% from 4.2%, while economists were expecting it to be unchanged.
What happened next is quite interesting. By 08:30:31, fear of a failing economy morphed into fear that the Fed was going to slow down its rate-cutting bonanza. By the close on that day, 2-year Treasury Note yields rose by +21 basis points, and 10-year Treasury Note yields climbed by +12 basis points. The former jump was the market adjusting its expectations for future rate cuts, pulling one off the table. The latter was bond traders factoring in a stronger economy which typically comes with… wait for it… inflation.
And just like that, it took about 30 seconds for the market to read through the data, and about another 1 second to completely shift focus from fear of a weak economy to… well… fear of a strong economy. By the following Monday, 10-year Note yields made it over 4% for the first time since early August. The actual 4% number doesn’t mean much, but Wall Street has a thing for round numbers, so a breach of that round number is kind of a thing. Yields continued to climb for the week and the following week saw a brief retreat back to 4% only to see yields bounce higher by some +20 basis points. That last surge probably had more to do with investors’ realization that the next US president will likely increase the Federal deficit to pay for all the promised stimuli and tax cuts (take your pick, both have handed out some big promises).
But it is clear that, right now, traders are looking at economic numbers with a “good is bad” lens once again. Good numbers, that is, a good economy means that the Fed may cut less, pushing short maturity yields higher. Similarly, a good economy means that inflation may be higher in the future, causing longer maturity yields to increase. Those big yield bumps combined with the evaporation of a “Fed put” are disconcerting to stock investors, and that is why we have seen equities come under a bit of pressure.
So, what is next in this new “good is bad” world? Well, how about GDP, itself? As mentioned above, we have that to look forward to next week when we get the advanced estimate for Q3 GDP. Wait, what? You mean, we will find out how well the economy did LAST quarter, as in the one that ended in September, and to boot, it is only the first estimate which will likely to be revised in coming weeks? Yes, I do. It is essentially a useless, backward-looking indicator of economic health. Now, I am not saying that we shouldn’t put any value on the release, but I am not sure that it is the most appropriate method to forecast future inflation. Enter, the Nowcast!
In the hallowed halls of the Atlanta Federal Reserve Bank reside some smart economists. Armed with a powerful laptop and a snazzy R-program, those economists have applied econometric techniques to forecast GDP… IN REAL TIME. They use a dynamic factor model to aggregate high-frequency data from various economic indicators and apply bridge equations to estimate quarterly GDP growth, updating their projections continuously as new data is released, ensuring the model reflects the most current economic conditions. How is that for a mouthful of technical mumbo-jumbo? Don’t worry, I can tell you that it is a solid methodology and about as accurate as you can get with state-of-the-art statistics. Do you want to know what those mathematical gymnastics have come up with? Of course, you do. Check out this chart and follow me to the finish line. Go on, your coffee won’t get cold; we are almost there ☕.
Please note two things on this chart. The model forecasts GDP growth to be at +3.4% TODAY, and that forecast has grown vastly from just +2% since September 1st. That forecast changed because of all the independent variables that have come out since then. In other words, the economic numbers that have statistical significance in determining GDP growth have been getting stronger. Is that a good reason for 10-year Note yields to climb? Probably. Is it a good reason to sell stocks? Probably not. Fight the urge to worry about how many rate-cuts the Fed will dole out before the end of the year and focus on what is important. Some 118 S&P500 companies have reported Q3 earnings to date. On average, they have beaten EPS estimates by +5.8%. We have plenty to go. Now get back to your coffee.
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