Calm Before Storm? Powell Friday Speech Awaited After Brief Yield Curve Inversion

Despite the Fed’s Jackson Hole summit starting today and a brief yield curve inversion late yesterday, things seem relatively quiet from a market perspective this morning

That could change quickly, as we know, but for the moment, it might feel refreshing to have a pause from all the fireworks. Stocks barely moved in most European and Asian markets earlier, and the 10-year yield scurried above 1.6% partly in response to some nice purchasing managers index (PMI) data out of Europe.

Still, yield caution hasn’t left the building after the 10-year and two-year yields inverted late yesterday. The spread remains pretty tight. There seems to be an element in the market expecting a recession, but the numbers aren’t backing that up.

Investors await Fed Chair Jerome Powell’s speech tomorrow, and earnings continue this afternoon with Ross Stores Inc. ROST, Gap Inc GPS, HP Inc HPQ, and Salesforce, Inc. CRM. The action at Jackson begins today with Philadelphia Fed President Patrick Harker and Dallas Fed President Robert Kaplan both expected to speak. Be on the lookout, too, for lots of headlines to pop up as Fed decision makers talk to the media covering the summit. Still, tomorrow will be the more important day.

Otherwise, people continue to discuss yesterday’s Fed minutes and strong recent retail earnings that provided more evidence of what the Fed called a “resilient” U.S. economy.

Fed Word of the Day: Recalibration

Judging from the July Fed minutes released yesterday, Powell wasn’t shooting from the hip when he said the July rate cut was a “mid-cycle adjustment.”

Those words seemed to spook investors when Powell used them at the post-meeting press conference, but the minutes provided evidence that it was no slip of the tongue. He was speaking for the FOMC and communicating that the Fed hasn’t entered a new paradigm of consistent rate cuts. We’ll see if there’s any evolution of that when Powell talks tomorrow.

According to the minutes, “most participants” saw the quarter-point cut “as part of a recalibration of the stance of policy, or mid-cycle adjustment” in response to changing conditions. At the time, it wasn’t what the market necessarily wanted to hear, but like it or not, it seems like the Fed wants to keep playing it by the data. 

As Reuters reported, the minutes showed a couple of policymakers wanting to cut rates by 50 basis points last month, but the majority agreeing that the Federal Open Market Committee (FOMC) shouldn’t give the impression that it was planning more rate cuts or following a predetermined course. 

This doesn’t mean the Fed won’t cut rates at next month’s meeting. Only that its members appear worried that they could start to look pigeonholed into an ongoing series of rate cuts no matter what happens with the economy. It sounds more like they want to keep their options open to respond to what’s going on outside the room.

The Fed funds futures market now puts chances of a rate cut in September at above 93%. What appears unlikely after the minutes is a 50-basis point cut. Earlier this week, futures pointed to a 10% to 15% chance of that. Now it’s zero, and futures put nearly 7% odds on no cut at all—something that hadn’t been built in until now. A lot can change over the next few weeks ahead of the meeting, and we have the jobs report in between now and then.

Yield Curve Inverts Again

In the near-term, the Fed minutes appeared to drive some volatility into stocks late Wednesday, but that quickly dissipated on a day when equities were generally strong. What’s more worrisome, maybe, is how the bond market responded. Soon after the minutes came out, the yield curve inverted for the first time since last week, meaning the two-year Treasury yield traded above the 10-year Treasury yield.

This could suggest that cautious investors returned to buying short-term bonds, maybe amid concerns that the Fed wouldn’t be enthusiastic to bring the big ammunition out to fight a recession or keep one from happening, analysts told the media.

The curve inverted during the last minutes of Wednesday’s session and didn’t appear to immediately cause a reaction in stocks. Last week, you may remember the 800-point session loss for the Dow Jones Industrial Average ($DJI) partially in response to a curve inversion. 

Something that happened last week but not this week, at least so far, was the 30-year yield falling below 2% and the 10-year falling below 1.5%. Both of those actually edged a little higher on Wednesday. So we’re arguably in a different situation than on the day the $DJI dropped 800.

It probably sounds repetitive, but it’s hard to over-emphasize just how attuned the stock market is now to bond yields. There still seems to be an appetite for caution when you look at the performance of short-term bonds. 

Healthy Consumer Still Provides Tailwind

The good news that drove stocks higher Wednesday came from the retail sector, where resilient U.S. consumers seem to be carrying the economy uphill on their backs.

Consumer Discretionary ran up nearly 2% gains to pace the U.S. market Wednesday, but all sectors finished higher. Lowe’s Companies, Inc. LOW and Target Corporation TGT earnings definitely lit a fire in the retail world.

As long as we have a healthy environment in jobs like the one we have right now, it’s going to be very difficult to shake people’s confidence. At the end of the day, if people are employed, they’re likely to go out and spend some money. As Bank of America Corp. BAC CEO Brian Moynihan said yesterday, the consumer is still spending and that could keep the economy in good shape.

It seems like retailers almost can’t do wrong. Nordstrom, Inc. JWN shares climbed sharply in pre-market trading Thursday despite the company cutting its outlook and missing third-party consensus on revenue. Earnings did beat consensus views, however.

As Barron’s put it, this might be an example of “the power of low expectations.” JWN has been one of the worst performers in the retail sector this year, but by actually beating analysts’ estimates on the bottom line, the company managed to deliver some good news.

Another retail stock up on earnings early Thursday was Dick’s Sporting Goods DKS, with gains of 10% in pre-market trading. The retail results continue to show the health of the U.S. consumer.

Continued hopes for a German stimulus might also have helped stocks on Wednesday, and European stocks actually outpaced the U.S. market. In fact, you could even argue that Germany’s 30-year bond auction at negative yields this week represented a little quantitative easing (QE). As some analysts pointed out, the auction demand was lower than expected, but what didn’t sell got retained by Germany’s central bank, the Bundesbank, to be sold at a later time. So it’s basically a QE: The government issued the bonds, and the central bank scooped them up.

We’ll have to wait and see if QE has any economic impact when rates are already negative. Some analysts think Germany has to get some fiscal stimulus into gear to make things move, and the country ran a surplus last year in a contracting economy. The textbook says governments normally would consider running deficits to spark economic growth in that situation.

FIGURE 1: LOOK OUT, TECHNOLOGY: The Consumer Discretionary sector (candlestick) has had its share of struggles this year. Lately, however, it’s heating up and even giving the high-flying Technology sector (purple line) a run for its money. Data Source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.  

No “Interest”: Just how much interest do investors have in buying a 30-year bond with a negative yield? Not much, at least at first glance. That’s how things turned out this week when Germany had a 30-year auction at a yield of negative-0.11% and only saw tepid demand. Why would someone buy a bond with a negative yield? Well, certain funds are contractually required to buy bonds no matter what the rate. Those who choose to buy, however, might be doing so because they think things might get worse, raising bond prices even further. It’s essentially a bet on deflation accelerating at a rate even faster than negative-0.11%. Or on the European Union potentially breaking up. 

Betting on Deflation? If you think deflation is on the horizon, maybe a negative-0.11% puts you “ahead” of the game. A long run of deflation for Europe isn’t out of the question, either, when you consider how hard Japan has had to fight that very battle over the last 30 years. Rates there are also under water. Both Germany and Japan are suffering from falling industrial and consumer demand as their populations shrink. Fewer young people are supporting more retirees in what some population experts call a “demographic time bomb.” That’s like a recipe for falling prices. For those who believe the U.S. is immune, consider this: Birth rates here are at the lowest level ever.

Finally Some Data: The week’s been a data desert for the most part, but the housing market comes into the spotlight tomorrow with new home sales for July. Consensus is for a seasonally-adjusted headline figure of 645,000, according to Briefing.com. That’s about steady with June. One thing to watch beyond the headline, however, is any downward revisions to previous months. That’s what happened in the June report when sales for March, April, and May all got revised lower. These reports are naturally backward-facing, so one positive on the home front is building permits, which rose in July. These give a better sense of what type of market builders see in the future.

Existing home sales released Wednesday actually brought some hope, too. The headline number outpaced projections, according to Briefing.com, and was up month-over-month and year-over-year. Median prices rose again, and supplies remained tight. Lower mortgage rates may be getting more people to buy, but if rates do start rising, the higher prices and low supplies could remain a headwind.

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