Now that the Fed appears to have abandoned its future guidance tool in favor of being “data-driven” to help determine its future course for rates, investors should monitor this gauge of inflation expectations for signs of a shift in market mood.
Watch the five-year flat rate inflation rate, one of the most reliable indicators of inflation expectations, to help gauge the monetary policy direction of the Federal Reserve, a team of macroeconomic strategists from Jefferies Group JEF,
The team said that the five-year break-even rate has helped predict the direction of stocks throughout the year, and can provide very good clues about the direction stocks might head next.
The five-year break-even rate represents the difference in yields between the five-year nominal Treasuries TMUBMUSD05Y,
The five-year Treasury Inflation Protected Note 9128286N55,
Bond yields rise as prices fall.
According to the Federal Reserve Bank of St. Lewis, this spread represents the premium that holders of inflation-protected securities demand, making it an effective proxy for market expectations of the average rate of inflation over the next five years.
After rising sharply in the first half of the year as inflation expectations rose and US stocks tumbled, the five-year break-even rate fell sharply in late June and early July, eventually reaching its lowest level in 2022 on July 6, when it collapsed below. 2.5%, according to St. Louis Fed data.
This latest drop, which coincided with lower commodity prices and Treasury yields, appears to have preceded the last phase of the stock rally. In July, the S&P 500 SPX,
Dow Jones Industrial Average DJIA,
and Nasdaq Compound,
Both had their best month in nearly two years, with the Nasdaq up more than 12%.
David Zervos, chief market strategist at Jefferies, said he expects stocks to continue to rally in the coming days and weeks, but will closely monitor the five-year break-even rate and economic data, in a note Sunday to clients.
“…[W]expect mail [Fed Chairman] Jay [Powell] He will carefully watch how inflation expectations respond to this fundamental change in the overall policy/directive attitude. So if inflation comes to a halt or inflation expectations survey data starts picking up, we’ll quickly see a change in Jay’s tone,” Zervos noted.
Measuring the Fed Axis
The recent dip in inflation expectations has led Fed fund futures traders to expect the policy rate will peak at 3.50% later this year, followed by interest rate cuts as early as next spring, according to CME’s FedWatch tool.
In response, economists from Deutsche Bank and analysts at Goldman Sachs questioned whether investors had become overly optimistic about possible rate cuts next year. But so far, US stocks seem to have ignored these concerns.
Looking ahead, investors will likely need to see a significant shift in inflation expectations, or a serious deterioration in labor market strength and the underlying economy, to trigger another round of sharp selling in stocks, Jefferies’ team wrote.
Because of this, the five-year break-even rate will be the “key metric to watch for pivot confirmation” for both the Fed and stocks, Zervos said.
Fed still wants 2% inflation
Fed Chair Powell repeatedly stressed the importance of inflation expectations in the press conferences that followed the meeting. On Wednesday, he reiterated that the Fed aims to “reduce inflation to our 2 percent target and keep long-term inflation expectations well anchored.”
Inflation in the United States remains at its highest level in 40 years through the end of June, according to the latest reading of the Personal Consumption Price Index, which was released days after the Fed rate hike last week. A day later, second-quarter gross domestic product data confirmed that the US economy contracted again in the second quarter, sparking further debate over whether the US economy has indeed descended into recession.
is reading: Is the US in recession now? Not yet – here’s why
Market-based indicators have been particularly useful at a time when the Fed has abandoned future guidance, leaving investors to analyze conflicting messages from Powell and other Fed insiders.
Many equity strategists have welcomed the prospect of a Federal Reserve pivot, or a move away from aggressive rate hikes, later this year. But Minneapolis Fed President Neil Kashkari told the New York Times and CBS News in recent days that the Fed is still “a long way” from backing off its inflation battle.
On Monday, Bloomberg News published an editorial penned by former New York Fed President Bill Dudley, who criticized “investors’ wishful thinking” about the Fed’s pivot as “unfounded and counterproductive.”
From a purely technical standpoint, some market technicians are expecting stocks to prepare for more upside, having recovered nearly half of their year-to-date losses.
For the S&P 500, the next major resistance level will be 4,178, according to John Kosar, chief market technical officer at Asbury Research. If the US index trades above this level for at least several sessions, the next major resistance level will be between 4279 to 4346. The next major “support” level for the S&P 500, if it declines, will be between 3922 and 3946.
is reading: US stocks struggle for direction after best month for S&P 500 and Dow since November 2020
US stocks lost their grip on modest gains on Monday afternoon. The main index was down 0.4% to around 4.105, while the Nasdaq Composite was down 0.5% near 12.316 in afternoon trade. The Dow Jones Industrial Average was down 0.4% near 32.698.