Tug of War

The stock market rally continued this week, but in between there was a lot of up and down action. The S&P 500 Index fell 1.6% on Wednesday, but still managed to gain 1.4% for the week as the market eventually managed to ignore the Fed’s rate cut delay. The yield on the 10-Year Treasury, which ended last week at about 4.11%, declined to 3.82% during the week, only to close at about 4.03%. Over the span of five trading days, these are both wild swings. So what happened?

The Fed Pushes and Markets Push Back

We are a mere 7 weeks removed from Fed turning on the green light for rate cuts and the December Fed meeting. In case you missed the action, two weeks after that meeting, the 7-to-10-year Treasury ETF (IEF) was up 3.3% in expectation of rate cuts. The S&P 500 Index hit a new closing record on Monday and again on Friday. After the brief midweek correction, it is now up 6.8% since the Dec. meeting. That’s an average of almost 1% per week!

Ever so briefly, the Fed took the wind out of the markets sails at the latest press conference on Wednesday. Here is a quick summary of what they said:

• • • It’s not enough that inflation has been down around the 2% target for the last 6 months. They want evidence that the current trend is sustainable. The concern is that goods are experiencing deflation, but service inflation remains elevated. Inevitably, goods inflation will return, so they need more progress on the services side of the economy to judge changes as ‘sustainable’.
    • While the door is technically open for a first rate cut in March, that appeared to be due to the Chair’s unwillingness to back himself into a corner. There is little chance of a cut in March, unless economic conditions, particularly the labor market, take a turn for the worse. That would place the earliest possible cut at the June meeting. The economy would have to go haywire to have another 5 rate cuts in the last 6 months of the year.
    • What happens from here depends on the labor market, not inflation. Chair Powell went out of his way to emphasize that the Fed has a dual mandate, price stability and full employment. In essence, as long as the labor market stays strong, they can afford to be patient with rate changes. They want to lower rates and at some point they will, but without being forced into a decision by weak labor data, it is a no brainer to make sure that inflation is ‘sustainably’ down before making that first rate cut.
    • What was unsaid, but has to be on their minds, is that the Fed does not want to be perceived as influencing politics. The first rate cut coming after the political conventions would put them in tough position as they would be damned if they do and damned if they don’t (although that may already be true). The only meetings after March that are before both conventions are scheduled for April 30-May 1, and June, 11-12. The path is least resistance for the Fed is for the first rate cut to come in June, if the data allows. The benefits of being patient diminish quickly after that meeting.

As we have been saying for a very long time, markets are almost completely dependent on what actions the Fed takes, or doesn’t take. There is often a disconnect between where the market is headed and where the Fed is headed because markets attempt to anticipate the future, which is where the saying ‘Buy the rumor, sell the news’ originates. The tug of war between the two can create strange weeks like this one.

After that December Fed meeting the market was discounting six rate cuts this year, which is a bit aggressive for an economy that just keeps chugging along no matter what is thrown at it. Interest rates coming down that much over a short period would suggest some meaningful economic weakness, which simply isn’t very visible at this point. The stock market became highly valued based on the anticipation of those rate cuts and was primed for some sort of correction, however brief. But by the end of this week, it was rate cuts be damned. It is onward and upward for the stock market, assisted by some strong tech earnings at Microsoft (MSFT), Amazon (AMZN and Meta (META).

The Bond Market Had a Similar Week, for Different Reasons

The unusual part of the Fed meeting this week was the bond market. With the Fed delaying rate cuts, one would have expected that market interest rates would move a little higher, but they didn’t. They actually moved sharply lower, until the Friday jobs report. The sharp move down was based on some renewed concerns about regional banks after New York Community Bank (NYCB) reported a spectacularly poor earnings report and cut the dividend by 70%, all because of losses from commercial real estate loans.

Commercial real estate problems aren’t a new story and the regional bank crisis of last Spring was perceived to have run its course, but the NYCB announcement seemed to revive the fear and the market appeared to be looking for the Fed to step in. Japan’s Aozora Bank piled on with bad news of their own. The stock dropped 20% on the report of property losses in the U.S. The regional bank index ETFs rallied a touch on Friday, but remained down hard on the week.

Like the stock market, the bond market also had a sharp reversal as the Dept. of Labor reported 353k new jobs (185k consensus) in January, well above even the highest Street estimate. That sent interest rates back up all over again. And poor news got worse from there, as December job gains were revised up to +333k from the prior +216k, and average hourly earnings (wage inflation) also surprised to the upside at +0.6% MoM Jan (highest since March 2022). That brought the YoY pace to a 4-month high of 4.5% vs. 4.3% prior and 4.1% consensus. Number like this will make very hard for the Fed to reduce rates in the near term. If there was any lingering doubt that the March rate cut was off the table on Wednesday, this report appeared to eliminate that possibility. When all was said and done, the 10-Year Treasury was still down about 8 basis points for the week (a basis point is 1/100 of a present) but had retraced most of the mid-week rate decline.

What We’re Reading

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‘Black Swan’ author Nassim Taleb says the U.S. is in a ‘death spiral’ over government debt

January hiring was the lowest for the month on record as layoffs surged

Fed Chief Jerome Powell says a March rate cut is not likely

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By: thinkhouse