Investors Remember What Rates Did Last Summer

In recent months, the specter of rising interest rates looms large over the market, evoking memories of past episodes of inflationary concerns. Investors in equities vividly recall the abrupt halt to their bullish streak when the 10-Year Treasury yield breached 4.3% last September and once again on April 2nd of this year. The ascent of interest rates tends to cast a shadow over stock market valuations as companies brace for heightened borrowing costs that can eat into their profits. Consequently, bonds start to appear more appealing compared to stocks in an environment where credit becomes costlier. A risk-free 6-month T-Bill offering 5.4% serves as a tempting harbor for cash, especially when juxtaposed with a stock market that has just concluded a robust 28% surge over the past five months.

The economy continues to outperform expectations, nudging inflation slightly above consensus levels. As long as the downward trend in 2-year inflation remains paused, stocks are likely to remain on the defensive if bond yields continue their upward trajectory.

Back in February, we acknowledged the brewing inflationary pressures stemming from robust consumer activity and a housing shortage. However, it seems that some market pessimists and media pundits are fixating on the wrong inflation metrics. The Federal Reserve, under the stewardship of Jerome Powell, keeps a keen eye on the broader core PCE price index, which has not exhibited any uptick this year. We suspect base effects will keep PCE inflation in the 2.5 to 2.8% range through July, after which a mild uptick may ensue into the elections if the economy sustains its current >2%growth trajectory.

 While headline CPI tends to focus on a narrower spectrum of price movements, with notable influences from housing, insurance, and geopolitically sensitive oil prices, some of these factors are expected to ease in the latter part of 2024. Housing, a significant component of CPI (33%) but less so in PCE (15%), is showing signs of deceleration, particularly in rental prices. The Fed’s higher for longer short-term interest rates will not immediately impact this crucial inflation component, given the lag it typically exhibits relative to apartment rents. Hence, it might be prudent to consider inflation trends excluding housing when formulating monetary policy. Notably, broader consumer durable goods prices have been experiencing deflation for over a year. 

Despite the current inflation concerns appearing somewhat exaggerated, our assessment suggests that the Fed will persist in reducing bank reserves and maintaining short-term rates above 5% until both core PCE and core CPI register consecutive months of declining year-over-year inflation. This monetary tightening, coupled with our overbought indicator index, led us to anticipate a 5% to 8% seasonal correction in major stock indices into a March trough. While stocks did experience a slowdown in March, the extension of our projected correction period until May was triggered by the breach of the crucial 4.34% yield mark on the 10-year Treasury. Notably, when this threshold was surpassed last September, stocks saw a 7% decline that month. Similarly, in April, breaching the 4.34% mark led to a 7% drop in the S&P 500 Index over the subsequent weeks, aligning with our correction forecast. Given the insufficient selling activity to shift our indicators back to oversold territory, it seems likely that another leg down in stock prices is needed to signal a resumption of the bullish trend. The market’s response to the upcoming core PCE inflation report April 26th will be telling. We anticipate a sub 0.3% monthly figure, marking a new year-over-year low below 2.8%. A result below 2.8% should be received positively by investors and could trigger a short-term rally in equities by the end of April before another wave of selling manifests.

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