Markets Showing Economy the Way?
Last week the Federal Reserve increased the fed funds rate by another 0.75%. This unanimous decision helped fuel a rally in U.S. equity markets as many participants believe the Fed’s pace of rate hikes will decelerate, while bond yields fell on slowing growth. Since peaking in June, 10-Year Treasuries have had one of their largest rallies in history with the 2s/10s yield curve inverting. As stocks and bonds have rallied together on what was perceived to be a more dovish tone from the Fed, market expectations of long-term inflation have started to rise again, illustrating the difficulty the Fed faces in shifting policy anytime soon.
2-Yr/10-Yr U.S. Treasury Yield Spread (Black), 3-Mo/10-Yr U.S. Treasury Yield Spread (Orange)
Source: Bloomberg
U.S. 5yr 5yr Forward Breakeven Rate
Source: Bloomberg
The U.S. economy contracted for a second consecutive quarter, a technical recession, as inventory drawdowns and a plummet in residential construction offset respectable trade figures and rising consumer spending. 2Q real GDP fell -0.9% from the previous quarter following the 1Q decline of -1.6%. Inventories took away 201 basis points from headline GDP growth with general merchandise stores as well as motor vehicle dealers continuing to unwind inventories as demand cools. Many companies ordered inventory to keep up with the levels of demand they saw as the economy recovered from Covid and to front run supply chain bottlenecks. This has led to excess inventory across a number of companies as consumers reshape their spending patterns to cope with high prices. Consumers remain under pressure as inflation crimps spending power, while the turbulence in equity markets continues to weigh significantly on sentiment.
As the economic data softens, this could allow the Fed to become more balanced in their messaging. The idea of “peak Fed hawkishness” has been discussed and could be driving both bond yields and potentially a turn in the U.S. Dollar. The initial move up in Fed futures supported the USD, so, if the Fed becomes more balanced, the dollar would have further to fall. This would likely help risk assets as equities hold an inverse correlation with the USD.
S&P 500 (Black), U.S. Dollar Index (Orange)
Source: Bloomberg
Last week’s decision by the Fed signaled that they are resolute on the current inflation crisis, and that market expectations of a Fed put are likely premature. Yes, they are now going to take things on a meeting-by-meeting basis, but they had already articulated this plan to get to neutral expeditiously, and then rely on the data for future action. While the bond market is potentially beginning to assume the Fed will get inflation under control, the cost could be great, potentially a recession while they are still tightening, which leaves a difficult backdrop for equities. As markets lead the economy however, this may already be reflected in the 23+% drawdown in the S&P 500 that we’ve experienced from peak to trough. The prices of copper and oil have come down significantly, which should assist in a cooling of inflation (July data is to be released next week). Tempered inflation data would provide the Fed further flexibility and may permit the soft landing that the bond market seems to be predicting.
WTI Crude Oil (Black), Copper (Orange)
Source: Bloomberg
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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