The market breathed a big sigh of relief this week after recent inflation data came in cooler than expected. While year-over-year CPI remains near 40 year highs of 7.7%, it was a marked slow down from last month’s 8.2% reading. Additionally, it offered more evidence that the peak inflation rate occurred in June, at 9.1%. The result: the best day for stocks since April 2020 and the best day for bonds in more than a decade. This isn’t the first time the market has tried to rally this year on better than expected inflation data. However, the scope of the move was forceful and the fundamental implications appear stronger than previous instances.
Bond yields finally peaked
All year, if you asked us to pinpoint the biggest problem for the market, it’s been that yields have kept rising. The two year Treasury yield for instance, was yielding 0.73% at the end of last year. It came into this week yielding 4.66%, a staggering rise of 538%! Why does that matter? Because treasuries are considered “risk-free.” So at 0.73%, the 2-year treasury is not very attractive. Who cares about a guaranteed return of less than 1%? But that math changes dramatically at 3% or 4%, and certainly the closer it gets to 5%. Making 4.66% per year for the next two years with no risk might be very compelling for a lot investors.
But there’s another element that’s been lost in the shuffle: the perpetual rise of the 2-year yield has kept buyers away from it.
What? But I thought you just said that making 4.66% risk-free is attractive?
Well, yes, but it was 1.5% in February, 2.5% in April, 3% in June, and then breached 4% in September. So why buy the 2-year Treasury at 4% in September if it’s just going to be at 5% in November? And why lock it in it at 5% in November if it’s just going to be at 6% in January?
That’s the thinking that had overtaken the market. That’s why I wrote back in May that the most important thing for stocks is for the 2-year yield to stop rising. Basically, everyone’s been in a holding pattern all year: no reason to buy bonds today if I can get a higher yield tomorrow; no reason to buy stocks today if I can get a lower price tomorrow. This created a negative feedback loop that has fed on itself all year long. Until this week’s CPI report changed the narrative.
What’s the new narrative?
The recent CPI report shifted the market narrative from, “the Fed is going to over do it and keep raising rates” to, “maybe inflation is finally coming under control and the Fed can stop raising rates soon.” And if the Fed is going to stop raising rates soon, then maybe yields are near the highest they’re going to be this cycle.
That immediately spurs giant demand for treasury bonds which were offering their highest yields in 15+ years. Because now the market stops worrying that the 2-year yield might go to 5-6%. So that 4.66% I can lock in right now? That’s super attractive. That 4.20% on a 10-year treasury? I’ll take it!
It was a mad rush to buy treasuries as soon as the CPI report showed slower than expected inflation. Yields fall as bond prices rise and look how fast yields fell as soon as the inflation report came out:
From there, the negative feedback loop of higher bond yields >> lower stock prices turns into a positive feedback loop of lower bond yields >> higher stock prices. Why? Because the performance bar that stocks have to hop over to beat bonds finally gets set in place. Investors can ask: “Okay, do I think stocks are going to return more than the 4.66% per year I can get from buying a 2-year Treasury?”
Previously, investors couldn’t answer that question because the input value was ever rising. Said differently, you couldn’t plug 4.66% into that question if you thought that number might just be 5% next month, or 6% in January. Where obviously the higher the yield gets on a risk-free security the less attractive risky securities like stocks become. Because why take any risk at all if I can make good money with no risk?
A game changer
So the plunge in bond yields really was a game-changer for the market because it provides much needed clarity for investors who are trying to decide where to invest their money. It gets them off the sidelines and they put cash to work. And there’s a lot of money on the sidelines. Fund managers were recently sitting on their highest cash levels since 2001:
Even if they put that cash to work in bonds instead of stocks it doesn’t matter because of our new positive feedback loop. If investors are buying bonds, that’s forcing bond yields lower. Lower bond yields mean I can’t make as much money in risk-free securities anymore. So if I want higher returns I better give stocks another look. See? Positive feedback loop.
This isn’t unusual either. Stocks and bonds have typically both done well following past inflation peaks:
So are stocks out of the woods?
So does all of this mean that stocks and bonds are going to rally uninterrupted from here? No, far from it. And the reason for that is Jay Powell and the Fed are scared to death that if the market rallies too hard it can refuel inflation. That is the last thing the Fed wants.
A preemptive market rally that goes too far, too fast, could fuel the wealth effect, loosen mortgage rates, and stimulate consumer confidence. Again, the Fed doesn’t want that. At least not until inflation has made its way back towards 2%.
But they also don’t want an all-out economic disaster either. Their goal has always been to pull off a soft-landing, where unemployment rises a little bit, growth slows, and inflation makes it way back towards 2%. Their own projections see a stronger economy than the one you read about from fear-mongering media outlets.
Much was made of Jay Powell saying in August that “some pain” will be involved in the Fed’s fight against inflation. However, let’s point out what he DIDN’T say. He didn’t say “our goal is to cause pain” or “we want there to be pain” or “our mission isn’t complete unless there’s pain involved.” No, he just stated a fact: that in the Fed’s fight against inflation, there may be some pain involved. And there certainly has been.
Stocks fell 25% on the year. Everyone’s feeling that, no matter what tax bracket you’re in. Layoffs are starting to pick up steam. Companies like Meta (FKA Facebook) announced their first job cuts in history. But how much of that is economic disaster versus the market just giving back some of the excess from 2020 stimulus and too-easy-for-too-long monetary policy?
A higher floor and lower ceiling
The implications of the recent CPI report and what we know about the Fed’s goal will likely combine to give us a higher floor in stocks but also a lower ceiling. Unless conditions deteriorate significantly, the 3,490 low in the S&P 500 this past October was likely the low for the year. Therefore, the recent lows between 3,850-3,750 should act as a “floor” for the foreseeable future.
Likewise, when the S&P 500 rallied to the 4,200-4,300 range over the summer, reports say Jay Powell was unnerved about the market ramping inflation back up on its own.
Thus, he used his Jackson hole speech to lay the smackdown on stocks. With that in mind, we’d expect that the S&P 500 will have a hard time moving beyond 4,150-4,250. Our logic being that if it gets up there before inflation has fallen back under 5%, Jay Powell and the Fed will work hard to talk it back down. And as we’ve seen all year, the Fed’s rhetoric has been a powerful tool in halting stock market rallies.
The bottom line is that the recent CPI report went a long way in improving sentiment. That’s because it sparked a rush to buy bonds, which drove bond yields lower. In turn, this brought clarity to a key question for the stock market: “how high are bond yields going to go?”
With that answer in tow, stocks were able to rally strongly. But as happy as we are to see some green on the screen, we’d temper expectations. This is still a market that is likely to be in a trading range for a while longer. The next key developments will be new inflation data on December 13th and additional commentary from companies on corporate earnings and employment.
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