Stocks Rally, Forgetting About The Italian Political Crisis

Fed No Longer Too Dovish

There was so much happening on Tuesday, I didn’t get to the effect the Italian political drama had on the Fed funds futures. The Fed funds futures were leaning towards 4 rate hikes in 2018 up until the Fed Minutes which dampened the market a bit. Still, the Fed pushing for 3 hikes in 2018 was more dovish than the market. The market pushed further towards the dovish side on Tuesday. As you can see in the chart below, the chance of 4 or more hikes in 2018 has fallen from about 45% to 10.5% in the past few days. The calculation of the probability varies among sources. The CME group shows the chance of 4 or more hikes is 22.8%, but that’s down from 32.3% as of May 25th. The political risk of the Italian crisis pushed off the ECB’s normalization process, which in turn pushes off the Fed’s rate hikes because they would push the dollar up given the dovishness the ECB and other advanced economies’ central banks are expressing.

Because of the flight to safety on Tuesday, the dollar index reached $94.84. With the dollar already moving up, it would create a big problem if the Fed added fuel to the fire of the dollar rally by raising rates. The dollar index was down $0.72 on Wednesday as the markets reversed, which I will review later in this post. With such a reversal, I was surprised to see the CME Group website showing that the Fed funds futures became more dovish on Wednesday, extending the movement from Tuesday.

Fed Slightly Upgrades Economy In Beige Book

The most notable event which could have affected the Fed fund futures on Wednesday was the release of the Beige Book. The main headline from the report was that the Fed upgraded the economy from “moderate-to-modest” to “moderate” growth. Most of the 12 districts were described as having “moderate” inflation and the rest had “modest” inflation. Ultimately, I think this description of inflation is meaningless because we’ll find out the truth on Thursday morning when the PCE report comes out. The PCE is expected to stay at 2% year over year and the core PCE is expected to decelerate from 1.9% to 1.8%. That provides little reason to hike rates. Even though we’ve seen economic strength especially in manufacturing, which was mentioned in Beige Book, the lack of inflation means the Fed shouldn’t raise rates more than 3 times in 2018.

Housing was said to be “modest” which is consistent with the recent weaker than expected reports. Retail sales were said to be “moderating” and auto sales were called “flat.” The biggest downgrade of this report was consumer spending which was described as “soft.” The Fed clearly is focused on the Q1 GDP report which was revised on Wednesday to 1% growth down from 1.1%. This missed expectations for 1.2% growth. The April personal consumption spending report on Thursday, which is expected to grow 0.4% month over month, will be more important than this older report.

Q1 GDP Growth Revised Down To 2.2%

The overall Q1 GDP report was revised lower to show quarter over quarter annualized growth of 2.2% which met expectations and was below the initial report of 2.3%. I was wrong to suggest growth would be revised upwards. The year over year growth was 2.8%. There were some big shifts in the underlying data which aren’t reflected in the slight tick lower in the overall report. The nonresidential investment increased 3.1% to 9.2%. This could reflect the improvement in S&P 500 firms’ capex spending as a result of the tax cuts. There were gains in investments in structures, intellectual property, and equipment.

Residential investment was revised lower by 2% to -2% because of the weakness in building and housing sales. Finally, as you can see in the chart below, the quarter over quarter GDP deflator was revised lower from 2% to 1.9%, missing expectations for 2%. The year over year price index growth has stabilized right below 2% in the past few quarters. The inflation is still below where it was in 2011, signaling the Fed doesn’t need to raise rates quickly this year.

The stock market is more focused on Q2 growth than Q1 growth. The news on that front is Merrill Lynch lowered its Q2 growth estimate 0.2% to 3.3% and Goldman Sachs raised its forecast 0.3% to 3.7%.

Review Of The Wednesday Market Action

The U.S. stock market completely forgot about the Italian political risk as it rallied sharply on Wednesday. The S&P 500 was down about 31 points on Tuesday and rallied 34 points on Wednesday which is 1.27%. The Russell 2000 exploded to the upside as it increased 1.5% after only falling 0.2% on Tuesday. I still think the Italian situation is far from resolved, but the S&P 500 has moved past it temporarily.

The original situation I mentioned where money flows into U.S. stocks at the expense of the European markets appears to have occurred as the STOXX600 was only up 0.27%. As you can see from the chart below, that would actually be consistent with the action since the bull market started. The S&P 500 is up 139% since mid-2008 while Germany is up 20% and Italy us down 37%. The Italian bond market calmed down as the Italian 10 year bond fell 25 basis points.

The U.S. Treasuries also reversed, but in the opposite direction as yields rose. The 2 year yield increased 9 basis points to 2.41% and the 10 year yield increased 7 basis points to 2.86%. This flattening of the curve pushed the difference between the two yields to just 44 basis points; that’s very close to the flattest of this cycle. There will be movement in curve if the PCE report misses or beats estimates on Thursday.

Conclusion

The stock market is right where it was at the start of the week. Ever since the S&P 500 broke out of the resistance that was the trendline of lower highs, it has done nothing. The market has barely moved in 2.5 weeks. I remain bullish on stocks despite the potential political landmines.

 

 

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