September 11, 2023
In our opinion, the near-term bullish narrative first needs to include an implicit or explicit announcement from the Fed that the hiking cycle has ended. Over the last ~6 months, various Fed officials have said they need to see at least three consecutive declining CPI or PCE prints to feel comfortable that we’re in a sustainably declining inflation environment. Unfortunately, the soonest we now see that happening is Q1’24. CPI base effects became a headwind in July and the August rally in energy prices probably takes headline CPI to +3.6% YoY vs. +3.2% last month. Those base effects dissipate in Q1’24 and hope for lower energy prices could result in Jan-March printing +2.9%, +2.7% and +2.6%.
Current pricing in the bond market suggests a ~37% probability for another rate hike, while the equity market has largely concluded the Fed is done with rate hikes. The Fed might be done with rate hikes, but we see it maintaining optionality in official policy statements until the end of Q1’24. We also note that the uptick in energy prices during the month of August resulted in the return of a positive correlation between bonds and stocks. This returns the market to a ‘bad news is good’ phase when it comes to growth data. A ‘bad news is good’ phase has the potential to quickly shift to ‘bad news is bad’ when labor markets and consumer credit deteriorate. Our first sign of deteriorating labor markets would come from weekly jobless claims spiking above ~260,000 for three consecutive months. Our earliest signs of deteriorating credit conditions would show up in rising High Yield Credit Default Swaps (CDX). Fortunately, neither indicators are showing signs of deterioration at the moment, but the SPX still needs lower bond yields in order to move sustainably higher. And lower bond yields will only follow disappointing growth/inflation data.