Big Reversal As Market Prices In More Rate Cuts This Year

Big Reversal As October Rate Cut Locked In

The stock market was down sharply Thursday morning because of the weak ISM non-manufacturing report, but then it rebounded throughout the day as the odds of a rate cut this month increased. The odds of 2 cuts by the end of the year also increased. I was wrong to suggest that stocks couldn’t be saved by more rate cuts. On the other hand, I was correct to point out that stocks were very oversold. By selling off in the morning, they hit the very oversold put to call ratio threshold that I mentioned on Wednesday. Stocks didn’t stay oversold for very long. You needed to act quickly to make a profit.

Specifically, the S&P 500 opened nearly unchanged and then plummeted 1.08% from 10 AM to 10:10 AM because of the weak ISM non-manufacturing report. The Markit services report clearly didn’t affect stocks since it came out at 9:45 AM. That makes sense because the Markit report was in line with estimates and the ISM report missed them sharply just like its manufacturing counterpart.

Stocks rallied throughout the day, closing up 0.8%. From the trough to the close, the S&P 500 rallied 1.79%. That’s a massive rally. The last time the S&P 500 fell at least 1% intraday and then closed up this much was December 27th. That was the beginning of the big rally that occurred in Q1. This type of reversal is a good sign. The S&P 500 has had this type of reversal 7 times since October 2011. 6 of those times have been since the start of 2018.

The odds of rate cuts spiked because of the weak ISM report. The chance of a rate cut in October increased to 86.1% from 77%. Usually, when the odds increase above 80%, it means the choice is locked in. As I mentioned in a previous article, we are getting very close to the point where the market usually locks in its answer. Once the Fed’s blackout period starts, it can’t impact the Fed funds futures market. The blackout window for this decision starts October 19th and ends October 31st. As I mentioned, the odds of a 2nd rate cut in December increased. The odds of 2 more rate cuts in 2019 went from 38.6% to 50.8%. If the Fed cuts 4 times this year, it clearly sees high risk of a recession. Keep in mind, if there’s a trade deal, the 2nd cut can easily go away.

Specifics Of The Action

The Nasdaq rose 1.12% and the Russell 2000 increased 0.45%. Because of the rally, the VIX fell 1.4 points to 19.12. I don’t think the increase above 20 on Wednesday was the last time it will get above 20 this month. The negative potential catalysts didn’t happen yet. The wild swings on Thursday caused the CNN fear and greed index to fall 5 points to 29 which is fear. Markets are fearful even though the S&P 500 is close to its record high.

The bellwether firm for the consumer, Costco, reported strong results that disappointed investors after the close on Thursday. Its stock fell 1.64% after hours. The firm reported $47.5 billion in revenues which missed estimates by $70 million. Net income was $1.09 billion or $2.47 per share which increased from $1.04 billion or $2.36 per share last year. The Bloomberg screengrab explains why I said the quarter was good. As you can see, Q4 US same store sales growth was 6.2%. Excluding changes in gas prices, forex, and an accounting change, growth was 5.2% which is still great. Ecommerce sales growth was 19.8%. These results signal the consumer is in fine shape. That supports the great August retail sales report and disagrees with the weak PCE report.

Every sector rose on Thursday after every sector had fallen the prior 2 days. Every selloff seems to make the media and some investors think a recession is coming, but you can’t overreact. There still isn’t evidence of a recession. The economy is simply slowing. The odds of a recession have increased, but not by enough for me to call for one. It was a broad based rally, unlike the selloffs which were centered in energy, financials, industrials, and materials. The best 2 sectors were tech and energy which rose 1.24% and 1.26%.

Treasuries rallied again. It’s no surprise the 2 year yield hit a new 2019 low because almost 2 cuts are priced in. The 2 year yield is now at 1.39%. The 10 year yield is closing in on its 2019 low as it is at 1.54%. It’s just 11 basis points above its year low. It’s record low, which it hit in 2016, is 1.37% which means if it hits a new 2019 low, the next step is its record low. The curve has steeped in the past few days because of the increasing number of rate cuts being priced in. The 10 year yield is 15 basis points above the 2 year yield. The 10 year yield will probably need to hit a new record low this year to keep the curve flat since the 2 year yield will keep falling as more cuts are priced in. The curve still isn’t steep enough to say a recession is underway.

Conclusion

Stocks reversed on Thursday. I will review the details of the non-manufacturing ISM report which caused the market to fall Thursday morning. On the one hand, I’m surprised more rate cuts were enough to save this market from a correction. On the other hand, I’m not surprised stocks rallied because they were very oversold. The weak non-manufacturing ISM report isn’t consistent with a recession. It will be interesting to see how stocks react to a weak BLS report since 2 more cuts are almost already priced in. The Fed is perilously close to 0% interest rates. We will know that this slowdown is worse than the 2015-2016 one if the 10 year yield hits a new record low.

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