What's in store for stocks and bonds?
The market is reacting to sticky inflation and strong economic data
I’m sharing my notes on what might be going on with the market right now:
Market has rallied off the October lows because inflation is declining while the economy appears intact. The icing on the cake is the AI boom. Feels like the Fed finally threaded the needle and long duration assets (e.g. tech stocks) have benefited the most.
But wait! While inflation seems like it’s declining, it will prove to be stickier than anticipated. Core PCE - the Fed’s preferred measure of inflation - has been flat around 4.5% for several months (first chart below) and real yields on 5+ year Treasuries remain negative suggesting the yield curve remains accommodative. Inflation remains well above the Fed’s 2% target. Powell can't be pleased.
Meanwhile, the 10yr-3mth yield curve inversion shrank by almost 50bps recently (second chart) as longer duration yields rise in response to stronger-than-expected employment data. I suspect the market is starting to price in a more hawkish Fed than originally anticipated. To squeeze the last drops of inflation out, the Fed may need to tighten more and for longer than anyone anticipated. Remember, the yield curve inverts in anticipation a recession (that can take up to 18mths to materialize) but begins to steepen as the recession materializes.
The last drops of inflation probably won’t get squeezed out without economic pain. Hot tip: everything seems fine until it isn’t.
Rising yields would negatively affect bond prices. Also, rising yields (i.e. rising cost of capital) and weaker demand could undercut earnings pressuring stock prices.