Yield Curve Flattens - Hawkish Fed Causes Stocks To Fall
Yield Curve Flattens - as Fed’s hawkish cut caused the stock market to decline moderately on Wednesday. Which is exactly what you’d expect. The market was pricing in 2 more cuts by the end of the year.
S&P 500 fell 1.09%, Nasdaq fell 1.19%, and Russell 2000 fell 0.69%. This was the worst day for stocks since May 31st. It’s no surprise the Russell 2000 outperformed because it has a heavy weighting of financials.
KBW regional bank ETF fell 0.49%. It had very volatile action in the afternoon as it rose 1% from 3:05 PM to 3:30 PM and then fell 0.83% in the last 15 minutes of the trading session. I would have expected the index to stay positive.
XLF S&P 500 financials ETF also fell 0.49% and had similarly volatile trading in the last hour of the session. Speaking of volatility, the VIX increased 15.64% to 16.12. Even with that large increase, it is near its long term average. CNN fear and greed index fell 5 points to 48 which is neutral.
As you can see from the chart below, stock market declines on FOMC days is the norm under Powell.
Yield Curve Flattens - That’s because the Fed has mostly been hawkish since he’s been in power, although, policy has changed recently with the dovish turn in late December and with today’s rate cut.
In 12 meetings, the Dow was up 3 times and down 9 times. Cumulative decline is 1,033 Dow points. Dow actually fell 334 points on Wednesday. This chart was made before the close.
Yield Curve Flattens - Sector By Sector Action & Treasury Market
Every single sector fell as this was a broad based decline. 3 worst sectors were consumer staples, materials, and technology. They fell 1.99%, 1.48%, and 1.47%.
Apple stock didn’t maintain all its after-hours rally as it only increased 2.04%. Facebook fell 1.43% as it is down 5.1% in the past 5 trading sessions. Colgate brought down the consumer staples sector as it fell 4%.
Main action was in the bond market as the yield curve flattened considerably. 2 year bond yield has risen to 1.89%. Which makes sense because the Fed is less likely to cut rates further. That’s a 13 basis point increase from July 18th.
There is now a 45.8% chance the Fed doesn’t cut rates in September which up from 28.7% 1 week ago. Even the Fed’s hawkishness couldn’t fully get the market away from a cut.
Fed will need to make a few hawkish speeches in August to further move the odds.
Yield Curve Flattens - If that occurs, the 2 year yield can get above 2%. There needs to be a 70% chance of an action for it to be fully priced in. So right now nothing is certain. Also, there's now a much higher chance the Fed cuts rates 1 more time (43%) in 2019 instead of 2 more times (31.7%).
And, there's an 18.1% chance the Fed does the previously unthinkable which is not cutting again for the rest of the year. 1 week ago there was a 9.8% chance of that.
10 year yield fell 5 basis points to 2.01% in reaction to the Fed’s decision which really flattened the curve. At one point, there was a 14 basis point difference between the 10 year yield and the 2 year yield which is just 4 basis points from the low for the cycle. There is now a 15 basis point difference as the 10 year yield is 2.04%.
If the Fed goes with rhetoric which makes the market think it won’t cut in September, the 2 year yield could get above 2%. The curve has a chance to invert in the next few weeks.
It’s interesting that just as Powell gave a mission accomplished speech on the economy avoiding a recession, he made the odds of a full yield curve inversion more likely. That inversion would point to a recession in late 2020 or early 2021.
Yield Curve Flattens - Very Terrible Chicago Fed PMI Doesn’t Matter
Chicago Fed PMI has a high level of accuracy in measuring the economy. That’s why the massive decline in the index spooked investors. However, don’t be scared because it was driven lower by Boeing which is based in Chicago.
That’s why you need to look at the details of reports and contextualize the data before going with a narrative. Specifically, the PMI fell from 49.7 to 44.4 which missed estimates of 50.5 by a long shot. Low end of the estimate range was 50.1. The chart below shows its high correlation with the quarter over quarter aerospace production index.
If Boeing didn’t cause this index to decline, I would be calling for a recession as the index hit a 4.5 year low. The employment and production indexes hit 10 year lows. There is no chance the ISM manufacturing index crashes this much.
Keep in mind, I’m a bear on the ISM PMI as I think there’s a good chance it falls below 50. It’s great that we get to see the ISM PMI on Thursday, which is a day after this report. There won’t be any lingering doubts about whether the Chicago Fed index means the ISM index will show sharp weakness. Even the flash Markit PMI, which fell to a 118 month low, was above 50 as it was 50.6. We will get that final reading along with the ISM one on Thursday.
Yield Curve Flattens - Conclusion
Fed’s hawkish guidance caused the stock market to fall, and more interestingly the yield curve to flatten. Many stated the 10 year 2 year curve would never invert this cycle.
One situation where it wouldn’t invert is if stocks fall sharply and the curve flattens, causing the Fed to become more dovish and steepen the curve. The curve can only invert if stocks don’t fall sharply.
Or if the Fed just ignores the correction related to its hawkishness.
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