This morning, it’s Core PCE
That markets are waiting to see
If it keeps on falling
More folks will be calling
For rate cuts ere end ‘Twenty-three
But what if the data is hot
That could put the Fed on the spot
Instead of a pause
That reading may cause
At least one more hike than was thought
As we head into the Memorial Day weekend, the market is awaiting some more key data points for the Fed’s calculus on inflation. Today brings a plethora of things as follows (median expectations from Bloomberg):
- Personal Income (exp 0.4%)
- Personal Spending (0.5%)
- Core PCE Deflator (0.3%, 4.6% Y/Y)
- Durable Goods (-1.0%)
- -ex Transport (-0.1%)
- Michigan Sentiment (58.0)
Given the Fed’s preference for the Core PCE as their key inflation indicator, this data point is always a critical feature of the monthly slate. However, since the FOMC Minutes were released on Wednesday, the market has already adjusted its views on the Fed’s future path. Since the release, the market has removed another full 25bp cut from the medium-term outlook, with pricing for January 2024 rising from 4.50% to 4.735%. It appears that the market is truly beginning to believe the Fed that it is going to remain higher for longer.
So, let’s look at the consequences of that policy stance and the market’s grudging acceptance. Over the course of the past 3 weeks, 10-year Treasury yields have risen from 3.38% to 3.78% after giving up 3bps this morning. Meanwhile, 2-year Treasury yields have risen from 3.89% to 4.49%, increasing the curve inversion again, and highlighting the market view that a recession remains in the not-too-distant future.
Generally speaking, the combination of higher interest rates and recessionary indicators tends to undermine the equity market, but that picture is more nuanced these days as the incredibly narrow breadth of the price leaders has been able to overcome a more general malaise. For instance, yesterday’s S&P 500 gain of 0.88% was largely the result of just three key tech names, NVDA, MSFT and AVGO, with the rest of the group mostly thrashing around. This continues the trend of a handful of companies driving the value of the “broad” market indices, a situation that cannot go on forever, but for now, it seems fine. Of course, the NASDAQ is even doing better since all those high performers are NASDAQ names.
However, one needs to ask, if the Fed continues to tighten policy further, and the market is now pricing a one-third probability that they hike another 25bps next month, and the result is a further slowdown in the economy, can these companies continue to perform? Maybe they can, but history is not on their side.
Other markets, too, have been impacted by the slow realization that the Fed means what they have been saying all along, higher for longer. While oil prices (+0.5%) are edging higher today, they have been significant underperformers along with base metals as concerns over future economic growth weigh on the sector. Both copper and oil have been falling for the last several months as the largest importer of both, China, seems to find itself with its own economic malaise. This is merely another input into the recession story.
Weakening growth in China and higher interest rates in the West to fight still too-high inflation do not bode well for economic activity for now. Add to these factors the potential outcome from the debt ceiling negotiations, reduced Federal spending in the US, and you have a trifecta of reasons for a negative equity and risk market outlook.
Speaking of the debt ceiling, this morning’s headlines indicate that the two sides are getting closer, but that spending cuts are part of the process. Naturally, this is controversial on the left side of the aisle, but the fact that not all the spending cuts included in the bill already passed by the House are going to be seen is controversial on the right side of the aisle. If anything, this sounds like an excellent outcome, where neither side is happy, but both agree something must be done. It is certainly no surprise to me that they are getting closer to agreement as this all has been part of the Congressional Kabuki that we regularly see on critical issues. Remember, though, avoiding a debt default is not a huge positive sign, it is merely the absence of a negative one.
Where does this leave us? Overall, the data remains mixed at best, with manufacturing indicators weakening, service indicators holding up, inflation remaining stickily high and the Fed continuing to pound its one main tool, the hammer of interest rate hikes on the economy. Perhaps the most interesting data situation is that of Initial Claims, which yesterday printed at a much lower than expected 229K. The fairly steady increases in layoffs that had been seen since the beginning of the year seem to be abating now. In fact, the 4-week moving average of claims data has fallen back sharply to 231.8K, an indicator that the trend higher may be ending. If this is the case, and the NFP data going forward remains robust, the Fed will have every reason to continue to tighten policy further, much further than is currently priced into the market. As I have written in the past, I continue to believe that NFP is the most important data point. As long as Unemployment remains low and jobs are created, the Fed will have all the cover it needs to maintain tight monetary policy. Just be prepared for some other things to break, à la SVB and First Republic.
Finally, a word about the dollar, which while modestly softer today remains in a clear uptrend off the lows seen early in the month. As long as the Fed maintains its current policy stance, one which is still being priced into the market, the dollar has further to rally. Although other central banks have been tightening policy as well, notably the ECB and BOE, the Fed remains the leader of the pack. Until the Fed finally halts, those two will lag and the dollar should remain strong. It is only when the Fed finally reverses course, which may not be until the middle of next year on current pace, when we should see any substantial dollar weakness. I would not hold my breath.
In the end, it all comes back to inflation. Until the central banks believe that they have defeated inflation’s threats, barring a calamitous economic collapse, I would look for bond yields around the world to continue to drift higher, for equity markets to struggle, although further gains cannot be ruled out, and for the dollar to maintain its overall strength.
Good luck and good weekend