For the last 18 months, single data points have regularly surprised the markets in both directions, inciting highly uncertain investors to project forward a “changed” economic outlook. This has led to rapid whipsaws of both bond and stock prices, and this past week was no exception. The CPI report triggered a substantial decline in bond yields, which led to a rally in equities, with a short squeeze as an accelerant. Rapid market moves typically flip the narrative and investors moods about the future change just as quickly; a good example of our human bias at work.
Why the Rally in Bonds and Stocks?
What a difference 0.1% can make. The latest CPI data came out on Tuesday and headline inflation was unchanged from October, due to lower energy costs, and was up 3.2% year over year. Of course, the FED is more concerned about core inflation, which excludes food and energy because those prices can waffle around. Core inflation rose 0.2% from October, and 4.0% year over year. In each case, the actual data was 0.1% better (lower) than expected. Despite the dangers of relying on a single data point, bond market investors took it as a definitive indication that Fed rate increases were behind us and rate reductions lay ahead. The stock market followed suit and took it as a definitive indication that the economy is headed for a soft landing and not a recession.
The incredible rally in stocks and bonds we witnessed on Tuesday is one of the more confounding characteristics of today’s markets: the speed and ferocity of market reversals. The reaction was extreme because markets were positioned for the opposite news. There was a very large short position in Treasury bonds (which would profit if rates went up) and a very large short position in small cap stocks, which would be most vulnerable in a recession. When the data suggested otherwise, short positions were quickly covered and new positions reflecting the ‘new reality’ were initiated, creating a stampede. In general, this is not unusual, but this week was exceptional.
In an effort to make that last comment a bit more meaningful, the chart below shows the volume of call options traded in the Russell 2000 Small Cap Index Fund, symbol: IWM. Almost 1.5 million contracts were traded, which is a new record. As a reminder, each contract is for 100 shares, so the total that traded was the equivalent of 150 million shares! The old record was just over a million contracts, a level reached for the very first time earlier this year. The average daily trading volume since 2014 is only 210,000 shares. This was effectively screaming fire in a crowded movie theater. There was a mad rush to re-position and that sent bond yields sharply lower and stocks sharply higher.
What Does This Week’s Market Reaction Mean?
The chart helps explain what happened this past week, the question is whether it is important. Our concern is that this is yet another overreaction to a single data point and markets remain vulnerable to new negative data points that can have similarly violent, and yet negative reaction.
It is hard to imagine this magnitude of market change is fundamentally justified for a difference of 0.1% in the inflation data. This rally was probably more about short covering and a new found belief that a soft economic landing is at hand; the traders U-Turn. We’ve been here before and we will probably go full circle several more times before there is a conclusion to this economic episode.
There is no question that inflation is coming down, and we have expected this result. We just are not convinced it will easily go to where the Fed wants it to be (2%). The argument the markets appear to be making is that month over month core inflation of 0.2%, or 2.4% annualized, is all that is required for the Fed to ease. In effect, the inflation story is now dead and buried. We are not so quick to judge. As inflation trends lower, it will be incrementally harder to make progress toward the 2% goal, especially in light of the re-shoring/friend-shoring of manufacturing, large wage increases in labor contracts, large fiscal deficits, etc. We’re not saying that the battle can’t be won, but we are saying that we see the hurdle for the Fed to cut rates in the short-to-intermediate term as much higher than the market currently perceives. The scenario for a rate cut in the short term would likely be one that could place more pressure on the equity markets.
Staying the Course
While PWM views the announcement about moderating inflation as positive, we are not concluding that a bull market has re-emerged or that inflation has been tamed to the Fed’s liking, or that a recession has been avoided. All are far from certain.
This recent rally simply erased much of the weakness we have seen in the past months, but we view the action this week as one of many potential “head fakes” that play on our human biases to change course. As we have discussed, we resist these pressures, choosing to remain focused on the longer-term.
What We’re Reading
Some Interesting Data from Deloitte:
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