Markets are in a bizarre place right now. On the one hand, the economic data over the last month or so has generally held in and in some cases even gotten better. As discussed in the last post on the Press and their Rate Cut narrative, inflation data has almost across the board gotten better over the last month, and in some cases significantly so (see August core CPI and core PCE as key examples). Additionally, yesterday's Services ISM report for August (https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business/services/august/) is another good example of non-inflation data coming in better than expected as well. Though not monolithic, several retailers reporting in the last several weeks have highlighted improving sales trends as part of the Back-To-School season (with Foot Locker being the most notable), providing some encouraging "micro" commentary to accommodate the "macro" data. That being said, its still very clear that the economy is slowing, and generally on weak footing. Real GDP growth is probably barely above zero right now, all things considered.
What's interesting about all this, however, is that the better-than-expected macroeconomic data and improving inflation data appear to be filtering into markets in conflicting ways. On the one hand, its good that the data is getting better, as it means the economy is digesting the current rate regime perhaps better than we thought, and if inflation is starting to come down, that should be indicative of the fact that a "true" recession may actually be less likely now that we thought. Said differently, the odds of a soft landing may actually be going up again, and the worst of the economic damage may be within our sights. The spread between the 10 year and 2 year Treasuries, a common recessionary indicator, has actually tightened by ~25 bps over the last few weeks all the while the Fed has been talking up the front end of the interest rate curve. A more hawkish Fed, all other things being equal, would likely cause this spread to widen (or said differently, to steepen), with the 10 year falling on recession fears while the two year rises on more Fed rate hikes. Instead, rates across the curve, both real and nominal, have been rising. The whole curve has been shifting higher, and its actually been flattening again. And importantly, this rising and flattening is not being driven by inflation. Inflation breakevens are back down to where they were prior to Powell's Jackson Hole speech two weeks ago.
A curve that's shifting higher and actually flattening in the face of a more hawkish Fed should be a bullish indicator for the economy. With rates across the board closer to 3.5% instead of 2.5%, Treasury markets are telling us the economy can support higher rates. But while this should be a generally bullish signal for the economy, the stock market has reacted extremely negatively to this latest change in rate regime. As of this writing, the S&P is now off 8.5% from its mid-August high. Why is the stock market going down if the economy is doing better than we thought and if inflation data is getting better? The answer is because the stock market is fearful that better data out of the economy gives the Fed room to hike rates further, thereby increasing the chances of a recession down the road. To be clear, the 10-2 Treasury spread is still quite negative by historical standards at close to -20 bps, so that market is still indicating recession. But the change in the credit markets relative to the change in equity markets is uniquely interesting.
Does this make sense? That all depends on whether better macroeconomic data necessarily means worse inflation data. There is a "good news is bad news" dynamic going on in the equity market again. Good news is being interpreted negatively because it gives the Fed more rope to hike. But, if the August CPI data (not to mention PPI and Import / Export prices) next week substantiates the improvement we've seen in the inflation data over the last month, then the pullback in equity markets probably doesn't make sense and stocks are likely to rally, simply because the Fed won't have to hike as much to subdue inflation. As of this writing, and after yesterday's August ISM Services report surprised to the upside, markets are predicting an 78% chance of a 75 bps hike. If August CPI comes in worse than expected, then equity market fears of more hikes to tame inflation will be justified, and 75 bps in September will be all but guaranteed, and stocks likely sell off. But if it doesn't, there's going to be a powerful case for 50 bps instead, and that will likely push stocks higher. We'll have to wait until next week to see.
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