Stocks fell Friday after the issuance of the July employment report. While equities rose at first following a report of less than 200,000 net jobs gained in both July and June (revised), concerns rose that wages increased at a 4.4% annualized rate. Bond yields fell with the 10-year Treasury retreating below 4.1% while the 2-year note fell to under 4.8%. Falling bond yields equate to higher prices. At least for the day, investors were selling equities and moving to the safer haven of bonds.
As noted last week, with earnings season winding down, the market’s focus is likely to shift from earnings to interest rates. Earnings season has been uplifting. While overall profits were lower than last year, they were still better than expected. As income was rising, economic data showed that the economy continued to grow amid signs of some slowing in the growth rate. This should allow the Fed to slow or even stop its steady increase in the Fed Funds rate. As more data confirms a slowing both in economic growth and inflation, confidence in a soft-landing scenario increases. But that doesn’t imply clear skies ahead. The economy so far has demonstrated that it can move ahead despite high interest rates. Cars are selling and consumers are buying new homes despite mortgage rates near 7%. The message to the Fed is two-fold. First, with both growth and inflation moving in the right direction, there is no need to be heavy handed on the interest rate front. Indeed, it is quite possible that the July increase in the Fed Funds rate was the last one. Second, if the economy continues to add jobs and the unemployment rate stays near multi-decade lows, there is no rush to reduce rates either.
Last week, in a volatile trading week for debt securities, the 10-year Treasury yield rose by 10 basis points while the 2-year yield fell by the same amount. Since mid-July, the 10-year yield has risen from 3.75% to almost 4.20% before settling back to 4.07% Friday. Markets call this pattern a bear steepener. Short rates remain rather flat as longer-term rates rise. This reduces the gap between the two ends of the curve making the yield curve less inverted. As noted, rising rates mean falling bond prices. Earlier in the current cycle, investors were betting on a hard landing. Repeated interest rate increases were going to bring on a recession. That would have forced the Fed to cut rates to stabilize the economy. Indeed, if one turns back the clock just six months and looks at the predicted path of Fed Funds as seen in the futures market at the time, investors were predicting multiple rate cuts in the second half of 2023. If short-term rates were destined to fall quickly as a recession unfolded, the proper path was to lock in long rates, even though they weren’t very high, with the expectation that soon the Fed would bring short-term rates back well below 3%.
As I have noted often, Fed Funds futures are a decent predictor of what the Fed might do at its next FOMC meeting. But if one looks past 60-days, the futures markets are as good at predicting rates 90 days or more ahead as the Farmer’s Almanac is at predicting the weather 90-days hence. With that said, the current consensus is that until economic data weakens to the point of making rate cuts necessary to sustain economic growth, it is likely that the Fed is going to keep rates at or near current levels for an extended period. Fed Funds futures still predict multiple rate hikes in 2024. But, as I just noted, take futures market predictions for what they are worth, very little. What’s more important is to try to surmise, assuming they are wrong, what the more probable path is likely to be.
The news lately, beneath the headlines, suggests some inflation worries. As noted in Friday’s employment report, wages rose 4.4%. That number is likely an understatement of reality as those leaving the work force earn more than those entering. This creates a persistent negative bias to the expressed wage inflation rate. To get to the Fed’s 2% target, assuming long-term productivity growth near its 1.5% average, wage growth would have to moderate to 3.5%. UPS, the largest unionized private services employer, just reached a labor agreement that promises an 8% wage increase in the first year. United Auto Workers are asking for 40% over 5-years. While they won’t get that for sure, they are likely to get well over 3.5% per year.
Beyond wages, look at selected commodities, notably oil and wheat. One factor helping reduce inflation over the past several months has been the moderation in commodity prices. While direct food and energy costs are removed to determine core inflation, they are still important input costs. Finally, if interest rates stay higher for longer, debt service costs will remain elevated.
I am not suggesting inflation isn’t going to continue to decline. As economic growth slows and technology increases efficiencies, inflation will come down. But the rate of deceleration we have seen in recent months isn’t likely to continue. It is likely to moderate. That’s the message of the bond market. Short-term rates should remain reasonably close to where they are today for some time. That might be a few months, or it could be many months. Meanwhile, if there is to be a soft landing or even a mild recession, the yield curve may just flatten and ultimately no longer stay inverted. That will ultimately happen with a combination of lower short-term rates and higher long-term rates.
This all impacts equity investors as well. When one becomes comfortable that investing short-term in the bond market can generate real returns, adjusted for inflation, then the appetite to take greater risk is reduced. Investors sell stocks and buy bonds. That is exactly what happened at the end of last week. While I don’t think it is reasonable to extrapolate a few days into a trend, I do believe that higher long-term rates over the past few weeks have served to moderate speculative fever and the pace of stock market price increases.
Earnings aren’t likely to be a major market driver over the next 60-90 days. The Fed is going to hold its annual gathering in Jackson Hole later this month. There will be an important CPI report coming this Wednesday that will be market moving. There will be an additional employment and CPI report before the FOMC meeting again September 19-20. Once we get past Wednesday’s CPI report, we will get into that part of the quarter where both corporate and economic news is rather light. August is a big vacation month. Thus, sparse news events can take on outsized importance. Historically, June-July have been more favorable to equities than August-September. After the sharp increase in equity values in June and July, a pause or moderation can recreate bargain values that will ultimately extend the bull market started last October. But for that to happen, commodity and bond markets must act favorably. No prediction here.
What we can predict is that a return to a world of higher nominal interest rates and higher real interest rates has economic implications for many interest-sensitive industries. It also argues to less leverage. Balance sheet quality takes on greater importance.
Last Monday, Treasury said its borrowing needs are increasing. The deficit this year is likely to be close to $1.5 trillion. In addition, the Fed is reducing its balance sheet by $1 trillion a year. While the U.S. government can always crank up the printing press and create as much money as it wants, without more buyers for its debt offerings, it will have to pay higher rates to entice investors. A lot has been written recently explaining that the real rate investors need has been reduced since the Great Recession. What was a 2%+ gap between real and nominal rates in the 1900s fell to near zero post-2008. But it is also true that the gap narrowed at a time when the Fed and other central banks were easing monetary policy aggressively. The growth in the supply of money overwhelmed the growth in demand moving prices lower artificially. Now the opposite is happening. Tight policy is widening the gap.
Eventually, central banks will move toward a more neutral stance, which should be the norm. Real rates should also return to a norm. That reinforces the notion of rates higher for longer. Higher rates mean lower P/Es for stocks. Both bond and stock markets compete for investor dollars. Higher real rates shift investors toward bonds. Negative returns move them toward stocks. While that doesn’t always happen perfectly, ultimately a balance is reached. A market P/E in the high teens suggests 10-year Treasury yields below where they are today. I am not going to try and predict where the 10-year Treasury yield will be 90-180 days from now. But where it sits months from today will tell us a lot about the direction of equity prices over the next six months.
Today, actress Charlize Theron turns 48.
James M. Meyer, CFA 610-260-2220