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Interpreting the Bond Market’s Message

In our Update of two weeks ago, we opined that housing prices had peaked, raising the prospect for headline inflation to follow. This was confirmed by recent housing data and commencement of layoffs as home sales slowed and builders hit the pause button. That leaves Energy as the remaining key to changing the current inflation narrative. Gas prices would have to peak before seeing trend change in headline inflation. This week we’re seeing oil trading nearly 20% off its June high and gasoline prices are beginning to follow. If this marks the arrival of Peak Energy prices as we believe, it appears likely that the Fed’s actions of the first half will have brought the rise of headline inflation to a halt. That would align with what we saw in the downticks of last month’s core inflation and producer price index data.

While stocks ping-pong daily with traders’ emotions, we more often look to the bond market for clues to the longer-term effects of the Fed’s actions. In the first half of the year, the Fed Funds rate was raised on three occasions by a total of 150 basis points. This coincided with the end of Quantitative Easing and officially marked the removal of the punch bowl for the US economy. Will the FOMC merely slow the economy or go too far, killing demand and triggering a recession? At the close of Q2, the stock market moved on from the inflation narrative to embrace the recession narrative as it posted a first half decline not seen since the 70’s. The bond market’s response has been more nuanced.

A few days in advance of the Fed’s June meeting we saw the 10-year treasury (a favored benchmark) sell off to yield 3.483%. Today, that yield hovers around 3%. Such a rapid move against rate expectations sends a message that can be interpreted two ways: One, the decline in yield points to impending recession and implies a risk-off approach to the equities markets. Or, it could indicate that the Fed is closer than previously thought to the end of its scheduled rate increases and that bonds mispriced a terminal Fed Funds rate predicted by many to be in the 3.5%-4.0% range. For now, we’ll choose Door #2, believing the bond market has dismissed the most extreme rate hike estimates and is pointing to a Fed Funds terminal rate of somewhere near 3%. If that proves to be the case, a soft landing for the economy likely remains within reach or, at worst, any forthcoming recession would be a mild one.

Summing up, we believe the boxes have been checked for Peak Housing, Peak Energy, and therefore Peak Inflation. We expect that to be confirmed in the months ahead. Unfortunately, the byproduct of achieving that is often Peak Earnings as consumption is tempered and margins are thinned due to already-high input costs. That could be partially priced into stocks now, but some sectors of the market could remain vulnerable to a negative surprise and a brief move to the downside. Next week’s economic data includes the latest CPI and PPI inputs as well as Retail sales. All will be in focus for the Fed prior to its July 26 meeting. Stay tuned.

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