For the first time in a long time, stock and bond markets are flashing divergent signals on the economy and future Federal Reserve policy. Tuesday’s inflation report will go a long way in determining which one is right.
Bond markets have been cautious. Yields on two-year Treasuries have soared by more than 30 basis points over the past two weeks as traders grow wary of the Fed’s hawkish messaging ahead of the latest reading on consumer prices. Stocks have been less worried. Amid the re-rating in the debt market, the S&P 500 has climbed almost 1.5% over that span.
The disconnect speaks to the alternate realities being priced in by the two asset classes. The front end of the Treasury curve has aligned with the central bank’s projections for an ultimate destination for rates that is above 5%, with some bold options traders bracing for a possibility of 6%. Meanwhile, the stock market appears to be priced for an economy that largely withstands the Fed’s bid to cool the inflation economy, a setup that will face a key test in Tuesday morning’s data.
“The stock market wants to have its cake and eat it too,” said Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors. “The market is pricing in a Goldilocks scenario of better growth yet continued disinflation, and probably underpricing the negative risks from both the growth and inflation sides.”
After the Fed’s campaign to combat the hottest inflation in decades battered stocks and bonds alike in 2022, both markets rallied to start this year as optimism grew that the central bank is nearing the end of its tightening campaign.
That twin rally has stumbled in recent weeks. While Treasury yields are still lower than at the end of 2022, two-year yields last week posted their biggest weekly rise since early November and continued to climb on Monday. While the S&P 500 slipped 1.1% last week, it wiped out those losses Monday, re-establishing 2023’s nearly 8% advance.
The rethink was spurred by January’s blockbuster employment report, which showed that the US economy added nearly double the number of jobs forecast. As a result, swaps traders now see the Fed’s policy rate peaking at about 5.2% in July, versus about 4.9% earlier this year. The repricing is more in line with the median projection of Fed officials at just above 5.1%.
Economists polled by Bloomberg expect consumer price growth to fall to an annual rate of 6.2% in January, down from 6.5% the prior month. The month-over-month reading is expected to rise 0.5% after falling by 0.1% at the last reading.
Yet a team of researchers at Deutsche Bank says that while core inflation has been falling since June, the pace has been less extreme than many might realize. They also note that some components, such as used car prices, have risen this year.
“The CPI is going to be a test of who’s got it right — the bond market or the stock market,” Art Hogan, chief market strategist at B. Riley, said by phone. “Right now, the anticipatory move in bond yields likely is right because the consensus is higher month over month on the CPI. Full stop. But the post-CPI-print reaction is where the test results come in.”
In addition to the obvious outcomes from Tuesday’s CPI — that bonds rise and stocks fall on a hot print, or bonds fall and stocks rise on a cool one — a third scenario is also possible, according to Hogan. It’s that a higher-than-expected inflation reading could be taken in stride by equities because it points to a robust economy, though he’d like to see a follow-through of that via a strong retail sales report later in the week.
The S&P 500 has over the past two months been reacting less negatively on CPI-release days, though they’ve still been volatile sessions, according to Jake Gordon at Bespoke Investment Group. That means “we’re still far from more normal levels of both CPI reports and the market’s reaction to them,” he wrote.
Equities have been rallying in recent weeks, with growth stocks outperforming since the start of the year. But they could come under pressure if the CPI print comes in hotter than expected, says Ellen Hazen, chief market strategist, and portfolio manager at F.L. Putnam Investment Management.
In that case, “you’ll see the bond market reflect the fact that rates are going to continue to go up for the rest of the year,” she said in an interview. “The stock market would give some back as it becomes more likely that the Fed needs to be more aggressive and constrain financial conditions even more.”
Source: Bloomberg
