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Now, read on below to know which market you should follow during times of uncertainty.
Stocks and bonds are telling the market two different stories.
According to the stock market, we’re on the verge of a new bull market. In this scenario, inflation has peaked, and the Fed will start backing off on interest rates.
If that’s true, then this idea should be validated by the bond market.
After all, the recent momentum we’ve seen in stocks is all about interest rate expectations… namely that they’re heading down.
But when you look at the bond market, not only is it not validating this idea – it’s actually saying the opposite…
Price Reactions to Economic Data Say It All
This idea came to a fever pitch after yesterday’s Consumer Price Index (CPI) report showed that inflation had no change on a month-over-month basis. But it was still up 8.5% from this time last year.
That’s “great” news and fed perfectly into the new narrative taking hold of stock investors’ imaginations (I described this narrative in my essay earlier this week).
It even gave the Biden administration a political weapon to declare…
Today we received news that our economy had zero percent inflation in the month of July.
Surely, the bond market would agree. Except, take a look at this chart…
It shows the 2-year Treasury yield, which is sensitive to Fed Funds Rate expectations.
There are two points on this chart worth noting…
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The yield is up 40-basis points month-to-date.
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It shows the jobs report released last Friday is much more important to the debate about the Fed than the CPI report yesterday.
Friday’s jobs report came in very hot… more than double what analysts expected.
That’s a very inflationary data point because more jobs mean more demand. Which then, lead to higher prices that run counter to what the Fed’s mission is… hence the price reaction.
On the other hand, yesterday’s CPI report had a different reaction. It showed cooler inflation than anticipated.
Which we already knew would come in light as I described in my essay on July 15. And commodities have been falling, which affects the CPI report with about a one-month lag.
So, where’s the surprise?
Well, although rates initially fell, they quickly retraced back up.
Now, the 2-year yield is trading back up to Friday’s highs. Which means the bond market is anticipating a more hawkish Fed, not less.
It also means the bond market doesn’t care about the CPI report. Or not nearly as much as the jobs report.
But the stock market couldn’t get more bullish, with the tech-heavy and interest rate-sensitive Nasdaq rising 2.85%.
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Who Do We Believe?
In fact, the Fed doves are pushing the idea that the Fed will cut rates next March.
But according to the Fed Fund swap market, expectations went from a Fed Funds rate of 3.25% on August 1 to 3.6% now.
So do we believe the stock market or the bond market?
Well, who would you rather believe in matters as important as your money? A brash, emotionally-prone person or someone who’s objective, calm, cool, and collected?
The stock market is emotional, whereas the bond market operates from necessity.
Every large corporation has a treasury department, which buys and sells all sorts of interest rate related products to finance and hedge operations.
Banks are most active because they’re in the business of taking in deposits and lending them out. This is all interest-rate driven and they don’t do it to speculate – they do it out of necessity.
But let’s also look at the track record…
While stocks were making new highs last December (right before the crash), interest rates were already telling us a different story.
Fed hike expectations were already rising and as a result, tech stocks were already underperforming the S&P 500.
The market acting out of necessity proved right and the emotionally charged market proved wrong.
It’s the same thing happening now.
And like last time, I would advise following the “smart money” because the stock market is beginning to operate on false pretenses.
Regards,
Eric Shamilov
Analyst, Market Minute
Reader Mailbag
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