The Dow’s winning streak of almost 3 weeks came to an end yesterday as a surge in bond yields in the wake of Wednesday’s FOMC meeting sent stocks into an afternoon tailspin. The most prominent economic news of the day was an advanced report showing Q2 GDP rising by a healthy 2.4%. Ongoing economic data showing economic strength brings into question whether Federal Reserve rate increases to date will be sufficient to win the battle against inflation.
10-year Treasury yields rose by their greatest amount in a single day since last September, topping 4.0% at the market’s close. Shorter term rates also rose but not to the same degree. Very often the true reaction to an FOMC meeting isn’t evident until the following day. So many institutional and short-term traders spend the afternoon of a rate decision unwinding prior bets, that it is hard to decipher the true market impact to a rate decision. Chairman Powell uttered all the right words Wednesday. He hinted that the July increase in the Fed Funds rate might constitute the end of the rate hiking cycle. But that would continue to be data dependent. While another pause is the most likely case in September, if there are not signs of economic slowdown and/or enduring progress bringing inflation back toward the 2% target, further increases might be necessary. As always, every meeting is a live meeting whereby decisions to continue raising rates are actively discussed. Whatever Powell or any other Fed official says today is merely speculation based on current facts.
The bond market is often a better reflection of consensus opinion. A rise in Treasury yields to 4% suggests two possible paths. One, it could take more tightening, which might include more rate hikes, to move inflation down on a path toward 2%. The other alternative is that while further rate hikes may not be necessary, the time to get inflation contained will be longer, probably suggesting that rate cuts will be fewer and later than markets have been anticipating.
A 10-year Treasury yield should reflect a combination of long-term inflation expectations plus a premium to reward lenders. That premium varies over time. In the recent past, it has even gone negative. In 2020 and 2021, when yields were under 1%, long-term inflation expectations were still persistently anchored in the 2.0-2.5% range. It was an aberration for rates to be below long-term inflation expectations for long. A 4% yield today suggests investors feel getting inflation back to 2.0%, versus 2.5-3.0% is going to be harder than optimists suggest. Yesterday’s GDP growth number only accentuates that point. 5.25% Federal Funds rates shouldn’t logically point to GDP growth of 2.5%. Granted there is a lag between policy implementation and economic effect. A slower pace of rate increases seems warranted, but monetary policy alone is unlikely to get inflation down to 2%.
I don’t want to lose sight of earnings season. So far, roughly half of the S&P 500 have reported. While over three-quarters of reporting companies have met or exceeded expectations, corporate earnings are on a path to fall 8% year-over-year. This is despite ongoing GDP growth. Obviously, the culprit is falling profit margins, or said another way, companies have not been able to recoup higher costs fully by raising prices.
Thus, in a nutshell, the June/July rally has been enjoyable for equity investors but both earnings and the bond markets have failed to give an all-clear signal. Earnings growth is going to be hard to achieve for several more quarters. Bond rates will remain elevated until there are persistent signs of improving inflation. In that regard, the two most important economic reports forthcoming are the August 4 release of July employment data, and the August 10 release of the consumer price index numbers. In the ideal, one wants to see job growth fall below 200,000 with an accompanying rise in the unemployment rate and moderating increases in wages. For the CPI report, one wants to see the core rate increasing at 0.2% or less. I offer no predictions beyond noting as I did Wednesday, that consumer services are well over 70% of consumer spending and closely related to wage trends.
With all this said, it was time for a breather. There have been a handful of times the Dow rose for a dozen consecutive sessions or more over the last century. There is no statistical significance to what happened over the subsequent month. Fundamentally, there is as much ammunition for a 5%+ correction as there is for a further 5% increase. Market rotation suggests that individual company fundamentals will be more important than macro economic factors. Next week’s key earnings reports will come from Apple# and Amazon#. Both reports will be unlikely to move markets overall. For now, how interest rates settle out will dominate near term direction.
Today, Jim Davis, the creator of Garfield is 78. Former Senator Bill Bradley turns 80.
James M. Meyer, CFA 610-260-2220