It’s amazing how 0.1% can influence market behavior. When the Consumer Price Index data was released yesterday, the monthly changes to both the headline and core CPI changes were -0.1% less than consensus estimates. Headline CPI was unchanged month-over-month and CPI ex-food and energy rose +0.2% when +0.1% and +0.3% were expected. Saying that both bond and stock markets liked the numbers is a vast understatement. Yesterday’s trading seemed to represent a sea change in sentiment.
The root of the astounding move in the yield curve was the perception that rate cuts are done. On Monday, Fed Funds futures showed a 28% probability for a 25 basis point hike by January, with a 75% chance for a cut by June, a 100% chance for a cut by July, and anticipated a 4.58% rate for December 2024. By the end of the day yesterday, if not shortly after the CPI report, there was a 2% chance for a cut by January and an 85% chance for a cut by May. A cut by June was fully priced in, along with a second cut priced in for July. Expectations for the December 2024 rate dropped to 4.33%.
Although the 20bp drop in 2-year Treasury yields seemed astounding, it fit completely with the statistics mentioned above. If the market is no longer pricing in a 25bp hike, it is logical, if not inevitable, that 2-year yields would reflect that change. It’s pretty straightforward arithmetic. Bond traders also removed a similar amount of yield from Treasuries with maturities up to 10 years. The potential for a rate hike vanished not only from Fed Funds futures, but from the bulk of the yield curve.
Considering that this month’s uptrend in equity markets was triggered by a drop in bond yields, it was quite understandable that stocks would have benefited immensely from yesterday’s falling rates. Stocks rose across the board, with advancers far outpacing losers. Even though the S&P 500 (SPX) and NASDAQ 100 (NDX) both rose about +2%, the biggest winner was the Russell 2000 (RTY), which was up over 5%. We have noted that many of the smaller-capitalization stocks in RTY are marginally profitable — if not outright money losers. They simply don’t have the access to capital markets that many of their larger peers do, so easing financial conditions should disproportionately benefit the constituents of RTY.
Unsurprisingly, bank stocks were major beneficiaries too. The cost of money dropped precipitously, and considering that banks’ primary input cost is money, it was quite understandable that their stock prices would rise accordingly. And as with the broader stock market, smaller banks outperformed their larger peers. The KBW Bank Index (BKX) was up 4.66%, but the KRE ETF, which tracks the S&P Regional Banking Sector, jumped an astounding 7.36%.
Yet the stock market’s thrall for bond yields seems a bit one-sided, at least today. Yields are up about 7-10bp this morning, but stocks are broadly higher anyway. RTY continues to be the leader, up about 1%, and KRE is up almost 2%. When we think cumulatively about the rallies that occurred Friday after the employment report, and yesterday, stock traders seem to have decided that the current move represents a major turnaround rather than a seasonal bounce off oversold conditions. The combination of decent, but not worrisome employment reports and better than expected inflation numbers certainly offer the possibility that the much hoped-for soft landing could be upon us. Economists may say possibility, but equity traders are betting on it becoming the likely scenario.
We have said before that “peak and pause do not mean pivot.” Recent developments seem to favor the idea that we have seen the last of the hikes in this cycle, and markets should be encouraged by that development, even if hikes were not the prevailing probability anyway. Whether or not the anticipated cuts will arrive is another matter. Bear in mind that futures markets have been pricing in imminent cuts even as rates were rising. Expecting two cuts in rapid succession over the coming months may be a bit optimistic. It seems unreasonable to assume that a rate-cut cycle will progress nearly as quickly as the hiking cycle does – unless of course economic circumstances dictate cuts. But that hardly gibes with the soft-landing scenario.
It will take months for us to know for sure whether the Fed and the economy will cooperate with investors’ current preferred scenario. But for now, investors are strictly glass half-full.
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