Last week, the S&P 500 (SP500, SPX) posted its first weekly loss in about a month. The culmination of a VIX expiry, Fed minutes and monthly options expiry helped break the stock market on Friday and potentially completed the summer rally dead in its tracks.
Now, maybe things get interesting, with Jackson Hole this week and a slew of Fed officials pushing markets back, concluding with Jay Powell himself on Friday, August 26.
Grounded in reality
While equity markets focused on a hypocritical Fed pivot, bond and money markets were grounded in reality. This reality shows that there is no pivot, and those betting on a future pivot will be wrong.
Fed Fund Futures show us that rates have risen sharply since July’s FOMC meeting, with two more full rate hikes starting in May 2023 through early 2024. is moved from January 2023 to April. . Fed funds futures now forecast more rate hikes and stay higher for longer.
Additionally, the spread between December 2022 and December 2023 Fed Funds contracts narrowed to just -11 basis points from over -40 basis points in July. This is a massive change in a short period of time, indicating that the market expects fewer rate cuts in 2023.
Even nominal yields seem to agree and have risen sharply since the weaker than expected CPI and PPI reports. Instead of lowering rates, they increased. Look at the yield curve, with rates rising between 15 and 20 basis points on the 5-year Treasury and the 30-year Treasury. Meanwhile, 2-year rates remained unchanged. If the market was eyeing a dovish pivot or inflation would suddenly crash, then rates should go down, not up.
Even the dollar index rose significantly. After initially plunging following the CPI report, the dollar index broke out, breaking out of a critical downtrend. It has risen nearly 4% since August 11 and nearly 1.5% since its July 27 lows. The dollar rose because it sees more hawkish monetary policy, and it had a massive move higher after the August 17 Fed minutes.
Meanwhile, since July 14, the S&P 500 is up 13.6% through August 19 and up 15.7% at its peak on August 16. This pushed the S&P 500 PE ratio year-over-year to 20.6. This is more than 3 points higher than its historical average dating back to the year 1954 of 17. Perhaps the most staggering feature is that in the 1970s and early 1980s, the last time inflation was that high, the PE ratio was less than 10. The big difference between now and then was that the rates were much higher in the 1970s and 1980s.
The high inflation rates of the 1970s and 1980s pushed the nominal 10-year rate to around 16% at its peak in 1981. Meanwhile, the spread or difference between the 10-year rate and the annual rate of the CPI was positive. Currently, this gap is deeply negative at over 6%. The only other two times in recent history that have happened were in 1975 and 1980. This suggests that if the rate of inflation doesn’t start falling quickly, nominal yields will have to push much higher in the future.
The big deal is that S&P 500 earnings over the past twelve months have been around $204, and at 17 times earnings, the value of the S&P 500 would fall to around 3,480. But the higher rates have to rise, the more the multiple PE will have to contract. For example, if the PE returned to the December 2018 low of around 16, the S&P 500 would be worth around 3,200.
In typical equity market fashion, it broke away, while reality is once again reflected in the bond market, currency market and fed funds futures. Stocks tend to be irrational when rising or falling, but this time they have become lopsided, and this recent summer rally may fade even faster than it has.
The summer fade can be especially true if Powell can deliver a clear and direct, non-two-sided message. Couple that with a slew of economic data set to be released between September 1 and September 3, which could likely support much higher rates and stay there for some time.