Divergent Economic Data to Give Fed Pause
Overall, earnings for U.S. equities have been significantly stronger than consensus expectations at the beginning of the season, inciting risk tolerance throughout the month of May. The S&P 500 posted nearly a 5% return in the month, and Thursday marked its 25th closing record this year. The path of least resistance for stocks has been higher on the heels of artificial intelligence elation, corporate profit growth, and optimism that the Federal Reserve will reduce interest rates later in the year. Stocks are making record highs despite the fact that for almost a year the Fed has held benchmark rates between 5.25% and 5.50% - the highest level since 2001.
Earlier today the U.S. employment report for May was released. Nonfarm payrolls surged by 272,000 from the previous month, easily surpassing the 180,000 that was expected. The unemployment rate unexpectedly rose to 4%, snapping a 27-month run of sub-4% joblessness, the longest such period since the 1960’s. The report set off the largest move in U.S. Treasury yields since the hotter-than-expected April CPI print, and the latest figures highlight the resilience of the U.S. labor market in the face of the steepest interest rate tightening cycle in decades. This strength risks keeping inflationary pressures stubborn and the Fed on hold before commencing their easing cycle. In fact, market expectations via interest-rate futures pricing are now showing only one 25 basis-point cut being fully priced in for 2024. Coming into the year, markets were pricing in over six. The U.S. dollar has been a direct beneficiary of the Fed being on hold as choppy inflation data has driven investors to scale back bets on rate cuts.
Next week more critical information will come to markets as Wednesday brings both the May CPI readings as well as the June FOMC rate decision. The largest peacetime deficit still needs funding, and this will keep upward pressure on both prices and federal interest expense. The amount of U.S. Treasuries outstanding has grown to $27 trillion, up from about $12 trillion a decade ago. Continued stubbornness in inflation could force the Fed to reevaluate when they ultimately begin to ease. Treasury issuance has been massive - last month the Treasury left its quarterly issuance of longer-term debt unchanged, after boosting them the three previous quarters in moves that brought some auction sizes to record levels. Last week a trio of dismal auctions contributed to volatility in yields with the lowest bid/cover ratios of the past 2-3 years. The Congressional Budget Office projects that chronic U.S. deficits will boost the U.S. debt to roughly $48 trillion by the end of 2034.
With a strong earning’s season wrapping up, equities could be left searching for a catalyst. This year’s corporate profit expansion is already priced into stocks, and investors will need to start pulling forward future expectations in order to justify valuations. Many things need to go right to avert a recession in 2025: inflation must subside; growth in the rest of the world needs to improve; and the labor market must find equilibrium. The rising debt load poses an ever-growing risk for the Treasury market, and the Fed is tasked with the unenviable job of trying to navigate it all.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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