Stocks are lower today in another mixed but flat session. If today's trend holds, we'll add 0.5% for the week, the smallest percentage change in five weeks - going back to when President Trump first tweeted about additional tariffs on Chinese goods. What this tells us is that the market is settling in after a bout of volatility. As we mentioned earlier in the week, the gains have been supported by the belief (hope?) that the Fed will cut rates a few times, starting in July. It's a strange market with stocks, bonds and gold rising. Even the Junk bond index hit a new high despite economic fears.
To begin the session, stocks started lower following Europe. Not much changed overnight but oil tanker attacks remained in the news. Gold however, is at a 14-month high, presumably helped by the geopolitical risk (Iran). Retail sales for May were lower (+0.5%) than expected (+0.6%) but excluding autos the numbers were actually better than expected, 0.5% vs. 0.4%.
Industrial production however, was higher at 0.4% vs. 0.2% estimated. Capacity Utilization was 78.1%, basically in line with the 78% expected. Meanwhile University of Michigan confidence was reported at 97.9 vs. 98.0 consensus and lower than last month's 100. However, the June current conditions index rose to 112.5 vs 110 estimated. All in, the numbers suggested that the economy is potentially strong enough to go without a rate cut so maybe that's why stocks are lower.
With no earnings and little market moving economic data, we are seemingly just waiting for next Wednesday's FOMC meeting for the next catalyst. Safety stocks are again leading the way while Energy is giving up some of yesterday's gain and Tech is the worst performer. Since seven of the ten largest companies in the world are tech, it's hard for the market to outperform when this is the case. Thanks to my colleague Massud for these ten companies: MSFT, AMZN, AAPL, GOOG, BRK, FB, BABA, Tencent, V, JNJ. See the table below for details on sector performance.
The S&P 500 is off to its best start since the late 1990's and within 3% of all-time highs. May's 3.6% unemployment rate is the lowest since 1969. Q1 GDP was 3.1% and consensus is estimating 2.5% for FY'19 and 1.8% for 2020. So why are we looking for a rate cut next week or the following FOMC in late July?
For starters, the S&P 500 is up just 0.5% from its January 2018 highs. That's a year and a half of doing nothing. And while we do not necessarily want our central bank to be reacting to the ebb and flows of the stock market, economic data and market measures argue a rate cut is appropriate.
As has been widely reported all year, the yield curve is inverted which is often a prelude to recession. The escalating trade war tensions certainly deserves some of the blame for this phenomenon, but so does the Fed. The eight rate hikes over the last two calendar years, combined with an unprecedented quantitative tightening policy starting in October 2017, appears to have been a bit much. We have previously highlighted how the yield curve was positively sloped the week prior to the December rate hike and ever since has been "going the wrong way" as trader's would describe it. Now the entire curve aside from the 30-year bond yield is trading well below the overnight rate.
Following the May 1st FOMC meeting, Chairman Powell said "we do not see a strong case for moving rates in either direction", however Powell has a growing reputation of saying one thing and in short order doing another. Since April 30th the 2yr and 3yr treasury yields have since fallen 43bps and 46bps, while the longer 10-year yield is off 42 bps. The 3year yield, 1.78%, is currently 57bps below the overnight FFR, 2.35%. Even if the FOMC delivers a 25bps rate cut next week, the entire curve out to the 10-year yield will still be below (inverted) the top of the range, 2.25%.
While some argue the Fed should not use monetary policy to bail out Trump's "aggressive" tariff strategy, they have a 2nd mandate outside of employment which they are not living up to. Both economic data and market measures of inflation have been in decline since the start of Q4. Core CPI has fallen from 2.2% in November, December, and January to 2% in May. The personal consumption expenditure (PCE) price index, the Fed's preferred measure of inflation, has fallen even more sharply from 2% (December) to 1.6% (April). The next PCE for May will be released on June 28th, after next week's FOMC.
Most market measures of inflation peaked in the middle of 2018 and by November started their decline. This week's decline in the 10-year treasury breakeven rate is the most since June 2017. It has fallen seven consecutive days, matching the longest consecutive streak of declines on record (21 years). Today's 2bps decline to 1.68% has broken down below the lows of both 2017 and 2018, currently at its lowest level since October 2016, and far from the Fed's 2% inflation target.
At the end of the day, the steepening inversion on the short end of the curve may be the most compelling reason to act sooner than later, even in the face of a solid yet slowing economic data. And while the S&P 500 was down 14.3% and 23.9% over the 12 months following the start of the last two rate cut cycles in 2001 and 2007, it averaged +15.8% in the 12-months following the previous five rate cut cycles in the 1980's and 90's according to LPLA's Ryan Detrick, CMT.
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