Good News Is Good News Again
Last month, in his keynote speech at the Jackson Hole Symposium, Fed Chair Jerome Powell removed all doubt that interest rate cuts are imminent. “The time has come for policy to adjust,” he said in his much-anticipated annual address. Powell’s sentiment confirmed that the Fed’s focus is now primarily on the “maximum employment” side of the dual mandate as the U.S. economy cools. Inflation risks have waned while labor market risks have increased. He added that the Fed would not “seek or welcome further cooling in labor market conditions.” Which all translates to a series of policy rate reductions in the coming meetings.
The U.S. employment report for August that is released tomorrow morning will give a clearer signal of the economy’s underlying momentum. Equity market participants have started cheering for good news on the economy once more because it would help demonstrate that the soft-landing the Fed has been aspiring for is still within reach. For most of this year, negative data was a boon for stocks. A weakening labor market, cooling inflation, and a slowing U.S. economy would allow the Fed to begin reducing interest rates. That, in turn, would provide corporations and consumers relief from higher borrowing costs – a positive signal for equities. There is a delicate balance, however, because a too-dovish central bank runs the risk of scaring markets over fear that the Fed is urgently cutting rates over concerns of a possible recession. Actual economic contraction is not good for stocks. But, if they ease rates too slowly, that could also weigh on stocks as short-term rates reprice higher.
After 26 months, for a brief moment yesterday the 2-year/10-year U.S. Treasury yield curve un-inverted. In the past, when sustained, this has been a signal that a recession was imminent. Several of the other classic recession signals, however, have yet to flash warning signs. The first is the copper/gold and oil/gold ratios. Both reflect the relative strength of global growth against risk aversion, as copper and oil are positively correlated with consumption and growth, while gold is positively correlated with risk aversion. And while both of these ratios have weakened as oil and copper prices have declined, they have yet to reach levels that signal a recession. Another indicator is corporate high-yield spreads. Typically, a recession is signaled if the yield spread widens to nine percentage points (900 basis points). Currently the spread remains very tight.
The U.S. dollar, meanwhile, is down over 3% since the beginning of last month as the impending Fed easing has come into clearer view. High U.S. rates strengthen the dollar and export inflation through dollar-denominated trade to nations with weaker economic conditions than the U.S. Any relief on the dollar will cut into energy prices, significantly helping heavy importers across Europe, Japan, and China.
The S&P 500 has never risen this much leading up to the first interest rate cut of an easing cycle. The impending rate cuts are fully priced. We need to continue to have a labor market that is not-too-hot, not-too-cold. We need to continue to have at-trend or above-trend economic growth. We need inflation to continue its downward trajectory. We need consumers to continue to consume in order to achieve a soft landing. Any deviation could upend the balance. So further volatility like we saw on August 5th remains a possibility. In a soft-landing scenario, small cap stocks will perform well as the sector is levered to falling rates. We remain constructive on MBS as the technicals remain supportive, and it is less sensitive to interest rate changes because mortgages overall remain far out of the money.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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