Treasury yields are swooning across the board this week in a way they haven't since the spring banking crisis. The chief culprit this time is the Federal Reserve, which not only isn't barking about a dramatic easing in financial conditions, but actually inviting investors to pile into bonds.
Yet even with a key Fed hawk talking of a possible near-term pivot to rate cuts, the S&P 500 has gone nowhere.
The 10-year Treasury yield, meanwhile, fell to 4.27% on Wednesday, the lowest since mid-September, extending big losses so far this week.
Several developments have fueled the plunge in bond yields, including news that Bill Ackman, founder of hedge fund Pershing Square, is betting on the initial Fed rate cut coming in the first quarter of 2024. After Ackman's dead-on call of the top in the 10-year Treasury yield in late October, his views carry extra weight.
Further, a slight upward revision to Q3 GDP on Wednesday included a downwardly revised 2.3% in the core personal consumption expenditures (PCE) price index, the Fed's key inflation rate. Then on Wednesday afternoon, the Fed's anecdotal Beige Book report of economic conditions around the country added to evidence that a significant slowdown is underway.
Fed Governor Turns Dove
Yet a decidedly dovish turn by Fed Gov. Christopher Waller, who has been a fixture of the hawkish consensus, provided the spark on Tuesday morning. First, he seemingly closed the door on further rate hikes, saying he's "increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2%."
In a speech titled "Something Appears To Be Giving," Waller explained that his confidence in the outlook stems from evidence the economy is slowing in the fourth quarter.
Next, Waller said Fed rate cuts would be warranted if inflation continues its easing trend over the next three to five months.
But almost as important was what Waller didn't say. In an Oct. 11 speech, Waller had alluded to the surge in the 10-year Treasury yield, noting, "Financial markets are tightening up and they are going to do some of the work for us."
Yet now the 10-year Treasury yield has reversed its fall surge, and the S&P 500's November surge has reversed recent losses. In other words, financial markets are no longer doing nearly as much to squelch inflation, but Waller seems fine with it. That was the dog that didn't bark.
Still, here are some things to keep in mind as markets adjust to the evolving interest-rate environment.
We Haven't Heard From Fed Chair Powell
While each vote on the Fed's policy committee counts the same, Fed Chair Jerome Powell is the chief consensus builder. In his Nov. 1 news conference, Powell said that the tightening in financial conditions with the rise in the 10-year Treasury yield could reduce the need for further short-term rate hikes. But that's only if the tightening in financial conditions is persistent, he stressed.
Since then, the 10-year Treasury yield has tumbled 61 basis points to 4.27%, including 21 basis points just this week. Powell had talked about a significant impact from near-8% mortgages, but the 30-year fixed rate has since fallen by 75 basis points, according to Mortgage News Daily.
Meanwhile, the S&P 500 has rallied 11% since Oct. 30, which may contribute to somewhat freer consumer spending than a market in correction. The recent fall in gas prices to the lowest level of 2023 also could support consumption.
While Powell has sounded optimistic about further declines in inflation, he'll likely want to wait for the data before taking it to the bank. Fed chair Powell will participate in a discussion at Spelman College in Atlanta on Friday at 11 a.m. ET.
Before that appearance, Powell will get to see October PCE inflation data, which is out Thursday at 8:30 a.m. Economists expect a tame 0.2% monthly rise in core prices.
In a Tuesday note, "Loose Fed Lips Sink Yields," market strategist Ed Yardeni of Yardeni Research wrote that he was "puzzled that the S&P 500 didn't rally more" in reaction to Waller.
Investors and traders may be waiting for Thursday's PCE inflation report to confirm that inflation is moderating, Yardeni wrote. "We expect it will do just that," potentially setting the stage for a Santa Claus rally to new highs.
Higher Real Rates May Persist
Why might investors see falling Treasury yields as something of a mixed blessing for the S&P 500?
For one thing, an inflationary environment can be good for pricing power and profits. Recall that Walmart stock tumbled 8% on Nov. 16 after management said sales growth would moderate in Q4 "as grocery inflation further normalizes toward historic levels."
In a Nov. 17 write-up FactSet noted that twice as many S&P 500 companies had issued negative Q4 guidance as positive guidance, 64 vs. 32.
Further, all declines in Treasury yields aren't equal. A concern in the back of investors' minds may be the extent to which higher inflation-adjusted, or real, interest rates persist.
For example, the yield on 10-year Treasury Inflation-Protected Securities, which is synonymous with the real 10-year Treasury yield, has pulled back 2.07% from a peak near 2.5%. But it's still nearly 50 basis points higher than it was on Aug. 1, when the big advance for the 10-year Treasury yield began.
A key question is what the Fed's new estimate of the neutral interest rate will be, meaning a policy rate that is neither accommodative nor restrictive. It will likely move higher from the current 2.5%, and that may happen as soon as Dec. 13, when the Fed will update its rate projections. The 10-year Treasury yield could settle a percentage point higher than the neutral rate, reflecting the term premium. That's the additional compensation investors require for holding Treasuries for a longer period.
If that's the case, the 10-year Treasury yield may not have much further to fall in a soft-landing scenario. And if it's not a soft landing, but a recession, as a minority of Wall Street firms are forecasting, the hit to earnings would outweigh the benefit of lower Treasury yields.
The Federal Reserve Broke The Budget. Buckle Up For What Comes Next.
Bank Stocks Outperform S&P 500
Overall stock market gains were muted in Wednesday afternoon stock market action, but the S&P 500 reversed modestly lower late in the day after the Beige Book painted a picture of a lackluster economy.
But bank stocks, though they came off their highs late in the day, are signaling better times ahead. A steeper yield curve, in which long-term Treasury yields are higher than short-dated Treasuries, is a positive for banks' net interest margins. That's because banks generally borrow at shorter-term rates and lend at longer-term rates.
But the yield curve has been inverted, with short rates sometimes much higher than long rates. The Fed's rapid-fire rate hikes past 5% have been seen as unsustainable in the intermediate term, so long-term rates have lagged.
Now we're seeing a condensing of the yield curve, with the two-year bond rate falling harder this week than longer-term Treasury yields. Optimism is rising that the yield curve largely dis-invert in 2024.
On Wednesday, Bank of America jumped 2.6% and is close to breaking above a long downtrend. JPMorgan Chase rose 0.5%, moving toward a buy point. Wells Fargo advanced 1%. All hit their best levels since mid-August.
Regional bank stocks, which have been hammered, are suddenly showing a pulse. Regions Financial rose 2.9% and Comerica 3.4%.
Be sure to read IBD's The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
