The cooling effect sends stocks into the go-go mode

Markets

Stocks are trading higher Friday, with the S&P 500 on pace for a ~6% gain for the week as investors have been reacting to a favourable mix of Goldilocks growth data and a Fed policy pivot that has brought rates down by ~40bp, as well as a generally constructive third week of earnings season that has helped to lift several stocks that set-up into the quarter with meagre expectations. 

But let's not forget about the US Treasury as many observers perceive the recent refunding announcement by Janet Yellen as equivalent to the first rate cut, given the extent of the financial conditions easing it has generated, especially when combined with the US economic data slowdown.

The three-session decline in 10-year US yields was nearly 35=40 bps by noon Friday, the most significant three-session decline since SVB collapsed. 

This week's turn of events has significantly twisted the screws and turned up the pressure on short covering of US dollar rates and Treasury positions and, with it, a short squeeze and an influx of exposure back into the equity markets.

Yellen's (and Brainard's) desire for an "everything rally" could be attributed to the fact that they are no longer part of the "apolitical" Federal Reserve. They may see the need to stimulate economic growth and bolster financial markets in the political context of an election year.

The cooling effect

The recent trends across various economic indicators indicate a cooling effect in various aspects, including employment, inflation, and manufacturing sentiment. These trends have so far been well-received by investors who were looking for signs of rate relief, which has indeed materialized.

 At the beginning of the week, yields on 10-year US Treasuries stood at 4.89%. They briefly climbed to 4.93% before the US Treasury announcement on Wednesday. However, they experienced significant drops after the FOMC statement on Wednesday, the unit labour costs released on Thursday, and Friday's payroll report. As of the current moment, yields on 10-year US Treasuries have retraced to 4.50%, effectively erasing a substantial portion of the increase that followed the September FOMC meeting when the possibility of rate cuts seemed more remote.

Let's delve into this week's data influx

1. Labour Cooling: The latest Payrolls report revealed a smaller job addition than expected, with 150,000 non-farm payrolls. Moreover, the unemployment rate, sourced from a separate household survey, inched up by 10 basis points to 3.9%. Tight labour markets have been a constant feature in the post-pandemic period, resisting efforts from monetary policymakers to temper them. While slower job growth isn't inherently positive, a somewhat more flexible labour market is likely to be welcomed by both the Fed and investors.

2. Further Inflation Cooling: Thursday's wage inflation report carried importance for both stock and bond markets, given their keen focus on inflation. Unit labour costs, representing compensation relative to output, declined by 0.8% . The year-on-year rate decreased by 1.8 percentage points to +1.9%. Compensation per hour stands at 4.2% year-on-year but dropped by 80 basis points. Notably, this deflationary wage trend occurred even as the unemployment rate remained low and job openings remained high. Hourly earnings data from the Friday Payrolls report also indicated some cooling off.

3. Cooling Manufacturing Sentiment: The ISM Manufacturing Index unexpectedly fell to 46.7 from 49.0 the previous month, reversing three consecutive months of sentiment improvement. Corporate sentiment has been somewhat out of alignment with actual activity for a while in the post-pandemic era. The latest ISM survey coincided with one of the United States' fastest-growing quarters in the past two decades. Despite this decline in sentiment, several industrial companies reported better orders, and their customers remain committed to significant projects, even as the cost of financing these ventures has risen.

4. Cooled Monetary Policy: The FOMC statement and the subsequent press conference this week were interpreted as slightly dovish. Chair Powell downplayed the recent rise in inflation expectations, clarified that above-potential growth is insufficient to continue hiking rates, and acknowledged that recent tighter financial conditions have essentially served as a substitute for a rate hike.

Our view

We believe the Fed will be less inclined to signal that rate cuts are on the near-term horizon. So far, the prevailing economic data doesn't strongly suggest an imminent US recession. This sentiment aligns with the view that the economic conditions, while moderating, are not signalling an imminent downturn.

Regarding the "Santa rally" prospects, a few factors are being taken into account:

The absence of a substantial surge in oil prices into triple digits suggests that global oil markets are not experiencing a significant supply shock. This, in turn, could be seen as a positive sign for the global economy, as it means oil prices remain stable.

The fact that longer-term US yields are failing to maintain levels above 5%, even for longer-dated bonds like the 20-year Treasury, is a potential opportunity for a tactical trade. In other words, if long-term yields remain subdued, it could create an environment where investors seek alternatives, potentially favouring equities.

Oil

Oil rose 30% after Russia's Ukraine invasion. Still, prices have been flat since the Israel-Hamas conflict, and it tells you one thing: there's no discernible supply curtailment from a contained conflict that does not bring oil-producing regional actors into the fray.

I don't think there is a need to debate the intrinsic need to hedge this tail risk, as it's obvious to some and not others.

We are in an election year, and it's doubtful the US administration will even attempt to turn down the geopolitical screws when dealing with Russia, China or Saudi Arabia, as the White House feels confident the global economy is much better positioned to absorb Middle East oil shocks than at any time in the last half-century.

On the supply front, we are likley reaching a point where the Saudis and the Russians can’t afford additional supply cuts. I'm sure other OPEC members are clamouring for more petrodollars, especially with shale oil starting to cut into the global supply pie.