Stocks rose for the third straight session as interest rates fell. I have been noting that, until earnings season, stock prices appear to be slaves to the bond market. After hitting a peak of 4.89% late last week, 10-year Treasury yields this morning are back down to 4.55%. That is a huge move over just a few days but not out of context with the size of the move up over the past several weeks. It attests to the lack of liquidity in the bond market.
That may sound strange given size of the bond market. But as has happened everywhere in the financial world, new derivative instruments have captured many markets. In the equity markets, trading in derivatives, including options, have surpassed volume in the actual stock trading platforms themselves. Bond traders are increasingly doing the same thing. When the majority want to be on the same side of a trade and employ the leverage inherent with the use of derivatives, the size of daily fluctuations is magnified.
Where should 10-year Treasuries be priced today? In theory, they should carry a premium to the rate of inflation. One wants to be paid in real terms to lend. While inflation was elevated over the past year, 10-year inflation expectations only budged a bit. If one uses an inflation adjusted growth rate of about 2%, and assumes the Fed over the next few years will return inflation to 2%, the 10-year Treasury yield should be somewhere about 4%. It is hard to make a case of something over 5% under the above assumptions.
Thus, the real questions are whether 2% growth and 2% inflation are reasonable assumptions. Note the Federal Reserve’s dual mandate is to maintain price stability (i.e., keep inflation close to 2%) while creating an environment that will foster economic growth. The Fed’s tool kit is large. The most efficient tools are its ability to fix short-term interest rates, and to increase or decrease the size of its balance sheet. There is little doubt the Fed has the tools to reset inflation to 2%. The question is how heavy-handed it must be in the process. Clearly, inducing a recession is inconsistent with the growth part of its mandate, but as Paul Volcker showed in the early 1980’s, such actions may be necessary over the short-term.
We are not, nor have we been in an overheated environment similar to the late 70s or early 80s. While exploding spending and ultra-low interest rates in response to the pandemic sparked some inflation, broken supply chains were a major contributor. All the easy money and artificially low rates increased demand. That alone was inflationary. But the broken supply chains were not the Fed’s creation. Then came the Ukraine war further disrupting supplies of key commodities. But now supply chains have largely been repaired, the Ukraine-related commodity price spurt is over, and the Fed has raised rates to a level that invokes a real cost to borrow. Demand is down, supply is up, and inflation is on its way toward 2%.
Does this week’s fall in interest rates suggest it’s all-clear? Not entirely. But it does, if only for a moment, erase a fear that runaway rates are going to lead to financial market turmoil. Congress is still dysfunctional. Restoring a Speaker of the House may only help around the edges. Auto workers are still on strike. The odds of a government shutdown in mid-November looms, although still less than 50%.
The biggest factor, near-term, will be earnings season. Pepsico kicked it off yesterday with a nice report. Given managements’ abilities to massage analysts’ earnings expectations, Pepsi beat estimates and raised guidance a touch. Pepsico is benefiting from the post-pandemic price increases it put in place. While volumes of soft drinks were down and snack foods were flat, the benefits from pricing more than offset the cost increases it incurred. In simple English, Pepsi managed its affairs well against a difficult background. The stock reacted and had a nice pop.
I expect the Pepsi story to be repeated throughout earnings season. Its shares had been buffeted recently by the impact of higher rates. Favorable earnings news and a lowered stock price reflecting interest rate and currency risks provided a backdrop whereby any good news could spark a rally. While the overall market is down less than 10% from its peak, many stocks are down 20% or more. Excess optimism morphed into excess pessimism. That creates an opportunity where any good news can spark a rally. Pepsico proved that yesterday and I expect the same reaction to be repeated throughout earnings season. Good managements adjust. It’s that simple.
But are we out of the woods completely? After interest rates peaked in October 2022, stocks headed higher for the next 9 months. I don’t expect the same strong rally again, largely due to valuation headwinds, but I do think some bargain hunting is now prudent. Seasonally, mid-October is a perfect time for a low. Whether we face a soft landing or a recession, the Fed is largely done raising interest rates. By next summer, it is reasonable to expect some rate cuts. By next year end, any recession should be in the rear-view mirror.
That doesn’t mean the world will be trouble-free. China, Israel and Ukraine are hot spots that could evolve into something that disrupts world economies. We face a campaign season with two very unpopular candidates. Washington spending is still out of control and debt issuance will be massive, keeping interest rates elevated. But it is earnings that drive stock prices long-term, and I would expect earnings growth rates to accelerate after either a soft-landing or brief recession. My 2-day rule suggests to start nibbling.
Today, Cardi B is 31. Michelle Wie turns 34. Former NFL quarterback Steve Young is 62.
James M. Meyer, CFA 610-260-2220