Stocks Go From Sacred Cow To Sacrificial Lamb

If Neel Kashkari was “actually happy” to see US equities fall following Jerome Powell’s terse remarks in Jackson Hole late last month, he must be elated now.

In six trading days since Powell’s address, the S&P managed just a single session of gains (figure below).

Friday likely would’ve been a decent session, with equities bolstered by a Goldilocks jobs report, but news that Russia isn’t restarting the Nord Stream following three days of “maintenance” undercut risk sentiment.

Stocks are now mired in a three-week losing streak. Notwithstanding Friday’s sharp move lower, real yields have risen dramatically, which bolstered the dollar and tightened financial conditions, to the chagrin of risk assets.

Friday’s Treasury rally found five-year reals falling 12bps, while the nominal curve “steepened,” with the scare quotes to denote that the 2s10s remains inverted, and the 5s30s, although back out to 5bps, re-inverted following Jackson Hole. Crowded flatteners (which have obviously worked) are probably being unwound, and the usual deluge of post-Labor Day corporate supply may contribute a steepening impulse as well.

For what it’s worth, TD pitched a long in 3s following the jobs report. “The market’s pricing for a 3.9% terminal rate is already consistent with an aggressive Fed path,” Priya Misra and Gennadiy Goldberg said. “Recent remarks from Powell and other FOMC members indicated a desire to keep rates higher for longer [and] this has led markets to price out the number of cuts after the terminal rate is reached,” they added, before noting that “the higher the Fed raises rates in the near-term, the more likely markets are to pencil in cuts in the future [which] should help buffer three-year Treasury yields from rising too much.”

Markets trimmed pricing for a third consecutive 75bps hike following the jobs report, which was accompanied by cooler-than-expected wage growth and an uptick in the unemployment rate, as participation matched the pandemic-era high.

Markets aren’t likely to abandon hopes for cuts commencing in the back half of 2023 no matter what officials say, but terminal rate pricing has firmed. “Jackson Hole marked the end of the ‘Mission Accomplished’ summer trade of peak CPI, peak yields and Fed cuts in 2023,” BofA’s Michael Hartnett wrote. “The rally unwound because inflation is unlikely to fall below 4% by 2024, thus 10-year yields and Fed funds are likely to exceed 4%” by then, he suggested, noting that market pricing (as shown above) for the rate path is back to levels seen midway through June.

“The only respite possible from even higher yields at this juncture is going to require significantly weaker US data, because the Fed is explicitly telling us they aren’t in a position to reverse current hawkish policy on account of still too-high Inflation, particularly in ‘sticky’ stuff and services [and] especially paired with a labor market which remains robust, and wage growth near record highs,” Nomura’s Charlie McElligott said.

In addition to the visceral aversion to higher yields, the problem for stocks is that as long as the labor market holds up, and particularly if gas and food prices ease, freeing up income for discretionary purchases and thereby keeping “sticky” CPI categories far too high for the Fed to relent, is that equities are the only real way for policy to throttle growth (figure below).

Officials have to engineer a reverse wealth effect. The economy is far too levered to stock prices. The Fed has to orchestrate a controlled demolition of the house they built.

Steven Blitz, TS Lombard’s chief US economist, summarized the situation. “With prices, employment and wages lining up to give spending a boost, the Fed is only left with driving down equities in order to reverse growth,” he wrote. Stocks, he said, “will be the catalyst, not the observer.”

There was a time when equities were the sacred cow. Now, they’re the sacrificial lamb.