The Fed's 'Acute Focus' on Inflation Good For Bonds?
The S&P 500 and the Nasdaq Composite bounced on Friday as Wall Street attempted to find its footing following a brutal week of selling. But all the major averages ended the week in the negative, with the S&P 500 posting its worst week since 2020.
The Dow Jones Industrial Average slipped 38.29 points, or 0.13% to 29,888.78, while the S&P 500 gained 0.22% to close at 3,674.84. The Nasdaq jumped 1.43% to 10,798.35.
Stocks were volatile during Friday’s trading, switching between gains and losses as investors grew increasingly worried about a potential economic slowdown.
Several key pieces of economic data fell short of forecasts this week, ranging from May retail sales to housing starts. Additionally, the Federal Reserve raised its benchmark interest rate by the most since 1994.
The S&P 500 closed down 5.8% for the week, with all 11 of its sectors finishing more than 15% below their recent highs.
The Dow closed again under the 30,000 mark after dipping below that level on Thursday for the first time since January 2021. The 30-stock average closed down 4.8% for the week, its 11th negative week in 12. The tech-heavy Nasdaq Composite also slipped 4.8%.
“It’s clear that there’s still some volatility and that’s a situation that’s going be with us for a while given the rising uncertainty,” said John Canavan, lead analyst at Oxford Economics. “I do think that after the extreme moves that we’ve seen over the past week, it’s sort of an exhausted market looking to a three-day weekend and just trying to find a place to settle in.”
Markets on Friday encountered a “quadruple witching.” This refers to the simultaneous expiration of stock index futures, single-stock futures, stock options and stock index options, which happens once a quarter. It typically leads to a surge in trading volume, making for choppy trading action or volatility as traders close out positions.
Beaten-up tech shares staged a rally on Friday. Investors have heavily sold off the growth sector as rates rise. Shares of Amazon jumped 2.5%. Apple, Nvidia, Tesla and Netflix added more than 1%.
Travel stocks Carnival and Norwegian Cruise Line also rebounded, jumping roughly 10% each. Airbnb and airline stocks also finished the session higher.
The Dow closed marginally lower on Friday, dragged down by shares of Chevron, Walmart and Goldman Sachs. American Express gained 4.9% and Boeing added 2.6%, cutting back some of those losses.
Consumer discretionary, communication services and information technology jumped about 1% on Friday but posted losses for the week. Energy continued its retreat, falling 5.5%.
Comments from the Federal Reserve Chairman Jerome Powell on Friday echoed the central bank’s commitment to tamping down inflation after hiking rates by 75 basis points earlier this week. The Fed is “acutely focused on returning inflation to our 2 percent objective,” he said.
The stock market’s weekly moves raised further questions as to when a recession will come, if it hasn’t already hit.
“Near-term recession has become a foregone conclusion for many investors; the only questions now are its duration and the severity of its impact on earnings,” said Chris Harvey, Wells Fargo Securities head of equity strategy said in a note Friday.
Federal Reserve Chair Jerome Powell reiterated his determination to curb the hottest inflation in 40 years and said the US central bank’s commitment encourages the world to hold and transact in dollars.
“My colleagues and I are acutely focused on returning inflation to our 2% objective,” he said in welcoming remarks Friday to a Fed conference on the international role of the dollar in Washington. “The Federal Reserve’s strong commitment to our price-stability mandate contributes to the widespread confidence in the dollar as a store of value.”
His comments were the first in public since the Fed on Wednesday raised interest rates by 75 basis points in the largest increase since 1994 and signaled more aggressive moves to come as they fight the hottest inflation in four decades.
Powell suffered a solitary dissent in Wednesday’s policy vote, though it came from an unexpected source: Kansas City Fed chief Esther George, who cast the first dovish dissent of her career.
In a statement explaining her decision later on Friday, she said that she voted against the 75 basis point increase “ because I viewed that move as adding to policy uncertainty simultaneous with the start of balance sheet runoff.”
The Fed commenced shrinking its massive balance sheet on June 1 at a $47.5 billion monthly pace that will double in September.
“For some time, I have advocated for stopping asset purchases and beginning the runoff of the $9 trillion balance sheet and returning interest rates to more normal levels,” George said. “However, the speed with which we adjust the policy rate is important. Policy changes affect the economy with a lag, and significant and abrupt changes can be unsettling.”
Powell told reporters at a post-meeting press conference that another 75 basis-point hike, or a 50 basis-point move, was likely at the next meeting of policy makers in July. Officials forecast rates will rise this year, to 3.4% by December and 3.8% by the end of 2023. That was a big upgrade from the 1.9% and 2.8% that they penciled in for their March projections.
Minneapolis Fed President Neel Kashkari said that while he supported Wednesday’s move and could back one of the same size next month, uncertainty about how much tightening raises caution about too much more front-loading.
“A prudent strategy might be, after the July meeting, to simply continue with 50 basis-point hikes until inflation is well on its way down to 2%,” he said in an essay Friday. “Obviously, in such a scenario, the FOMC would still need to remain data-dependent and have the flexibility to account for economic developments that might arise.”
The Fed chief, in his remarks on Friday, said the central bank’s ability to meet its goals for both maximum employment and stable prices depends on maintaining financial stability.
“The Fed’s commitment to both our dual mandate and financial stability encourages the international community to hold and use dollars,” he said.
He also highlighted the role played by the Fed’s liquidity swap lines and its standing repo facility for making it easier for foreign central banks to gain access to dollars in times of stress.
“Both facilities enhance the standing of the dollar as the dominant global currency,” he said.
This was another tough week in markets as the Fed decided to aggressively hike rates by 75 basis points on Wednesday, the most since 1994, following last Friday's US CPI report which showed inflation rose 8.6% in May from a year ago, the highest increase since December 1981.
The market reaction was initially good as short sellers covered on Wednesday afternoon following the Fed's decision but they came back full force on Thursday to drive stocks lower.
On Friday, things are calmer as we head into the long weekend in the US to celebrate Juneteenth.
The big worry right now is whether inflation will persist, forcing the Fed to keep hiking rates aggressively at its next meetings.
The good news on Friday is oil prices are down almost 8% and so is the yield on the 10-year Treasury note.
In fact, after hitting a high of 3.48% on Tuesday, the yield on the 10-year Treasury note has declined to 3.22% today:
The decline in long bond yields reflects that investors are expecting the US economy to slow and inflation pressures to abate.
This is also why tech shares are up today because if rates are peaking here and the economy is slowing, it tends to support growth stocks.
Of course, the Nasdaq being up 1.4% on Friday doesn't really mean anything after a brutal week and investors are rightfully cautious here:
The same goes for the broader S&P 500, growth stocks have weighed it down this year and the big worry now is with the economy slowing and teetering on a recession, it's spreading to other sectors and we are headed for an earnings recession in the second half of the year:
Keep in mind, the backup in long bond yields caused a multiple compression but the earnings recession can send stocks lower, especially if the economy slows significantly in the second half of the year.
Roughly ten days ago, Francois Trahan of Trahan Macro Research had a conference call looking at whether equities have fully discounted the slowdown ahead and he argued convincingly that the Fed still has some catching up to do to raise rates and that market corrections reach the worst phase when EPS decline and the ISM declines below 50.
Importantly, Francois thinks the inflation outlook will remain challenging for the foreseeable future and if you connect the dots, that makes the Fed's job a lot tougher and raises the risk of a policy error.
Again, markets don't go up and down in a straight line but with an earnings recession looming, there will be plenty of pitfalls for stock investors in the months ahead.
Is an earnings recession priced in? No, earnings estimates remain elevated and depending on the severity of the downturn (hard or soft landing), it will materially impact earnings.
Moreover, with global central banks pretty much on the same page now, it becomes a much harder environment for risk assets but it boosts the outlook for bonds.
In fact, Martin Roberge of Canaccord Genuity wrote this in his weekly Portfolio Strategy Incubator:
For the first time since March 1988, the Fed raised its policy rate Wednesday while the S&P 500 is in a bear market. Since this hike coincided with other central banks increasing rates and a slew of soft economic data (more below), it did not take long for investors to press the sell button. As a result, equity markets have begun to price in the prospects of a recession, as suggested by the jump in correlation among S&P 500 constituents (see our note here). With the tightening cycle going global, upward pressure on bond yields seems to be abating. As such, US 30-year Treasury yields failed to break above the 3.50% 2018 resistance level. Ditto for the euro, which is holding above the key 1.04 level, thanks to the ECB’s intention to unveil a backstop to prevent a spiral in peripheral bond yields. Another green shoot is the decline in both energy and non-energy commodities, which increases odds of tamer inflation data in H2. In all, this week was all about de-risking portfolios with the bear using its paws to capture cyclicals and defensives. Growth outperformance should not come as a surprise since absolute valuations have already collapsed below historical averages. As we wrote this week, we doubt the growth will underperform through what could be the last stage of the bear market in Q3.
Our focus this week is on the relative performance of stocks and bonds. When this week’s rout in stocks is accounted for, both asset classes have performed equally over the past year, with the annual change in the stock-to-bond ratio (S/B) falling to the zero line. Going into the third quarter, however, odds favour bonds’ outperformance if our Chart of the Week is any guide. As we can see, even through the soft landings of 2012, 2016 and 2018, the annual change in the S/B ratio bottomed in the -10-15% range. Second, a reversal in the S/B ratio appears unlikely before there is a net upturn in global LEIs, as portrayed by the OECD LEI diffusion index. Last, each growth scare over the past few years has seen the S/B ratio testing its 100/200-wma. Otherwise, a broadening tightening cycle globally provides a blanket for bond yields while stocks still have to navigate through what should be a challenging Q2 earnings season if our profit proxies are any guide. Thus, we reiterate our pecking order whereby bonds = commodities > stocks until our ~30% downside target on stocks is reached.
Of course, with the Fed also engaging in quantitative tightening, it's unclear how this will impact long bond yields, although it is not selling its Treasury holdings outright, just letting them run off and not buying as much as before.
If the upward pressure in bond yields is abating as inflation pressures peak, then now might be the best time to invest in long bonds after a brutal first half of the year:
As far as high yield bonds, junk bond spreads rose to their widest since October 2020 this week, hammering the high yield market and this too doesn't augur well for stocks:
Again, how bad does it get? It all depends on inflation pressures and whether the Fed will have to keep raising rates aggressively after its next meeting, elevating the risks of a policy error.
The most important thing to watch for now is inflation trends over the next three to six months.
If inflation pressures abate, this will make the Fed's job somewhat easier in engineering a soft landing.
However, if inflation pressures persist, then that makes the Fed's job a lot harder, raising the risk of a policy error and a hard landing.
Remember, interest rate hikes take months to work themselves into the real economy but with mortgage rates hitting 5.78%, the highest level since 2008, it is impacting housing, signalling a slowdown lies ahead.
Recession becoming clearer by the day. Citi’s economic surprise index just retreated to a new post-COVID low. Worst level since May 2020. I realize this comes as a surprise to all those who think that recessions are some mythical part of the business cycle. That’s their problem. pic.twitter.com/q1pVsc0zdb— David Rosenberg (@EconguyRosie) June 17, 2022
The decline in stocks and high yield bonds also doesn't augur well for the overall economy.
All this means maybe there is good news for bonds and eventually stocks but if inflation pressures persist, investors will need to prepare for a nasty recession and prolonged bear market.
It's way too soon to reach that conclusion but if inflation pressures persist, it's highly likely we will see a lot more pain ahead.
Below, PIMCO Market Strategist Portfolio Manager Tony Crescenzi joins Yahoo Finance Live anchors Brian Sozzi and Brad Smith to discuss inflation, stock futures, Fed policy, and the outlook for investors stating 'there’s a wide band of uncertainty' around the Fed'.
Second, Richard Fisher, Former Dallas Fed president, breaks down the Fed's latest rate move. With CNBC's Melissa Lee and the Fast Money traders, Steve Grasso, Guy Adami, Karen Finerman and Tim Seymour.
Third, Mohamed El-Erian, Allianz chief economic advisor, joins 'Closing Bell' to discuss what he makes of the Fed decision to boost rates by 75 bps, how he interprets the recent economic data and thoughts on potential defaults around the world.
Fourth, Ron Insana, Schroders North America senior advisor and CNBC contributor, joins 'Power Lunch' to discuss what he thinks about the current investing landscape, potential worries around the Federal Reserve's decisions and historic markets he believes are similar.
Lastly, the Federal Reserve on Wednesday launched its biggest broadside yet against inflation, raising benchmark interest rates three-quarters of a percentage point in a move that equates to the most aggressive hike since 1994.
Fed Chairman Jerome Powell takes questions from reporters as investors await cues on the central bank’s projections for economic growth, inflation and its future path for rate hikes.