This week, the focus will shift from the labor market to inflation, with the CPI report due out on April 12. The report is expected to have a significant ripple, as the core CPI is expected to have risen more than the headline CPI. for the first time in a long time, which clearly proves that inflation is sticky.
If the overall CPI meets or falls short of expectations, it won’t matter; the Fed is still likely to raise rates by 25 basis points in May. The likelihood of a Fed rate hike rose from around 50% to 70% ahead of the jobs report. Unless there is a significant failure on the CPI, it won’t matter; the Fed’s objective is to push the Fed funds rate above 5% because inflation remains too high.
This development could disrupt the equity market, as it has already priced in a Fed pause and rate cuts, given the recent rally since mid-March and the strong performance of the tech-heavy, interest-rate sensitive NASDAQ.
The jobs report was stronger than expected
The main survey employment report for non-farm payroll establishments was stronger than expected, with 236,000 jobs added, above estimates of 230,000. Last month’s figures were also revised upwards to 326,000 from 311,000. The household survey saw even bigger beats, with the unemployment rate falling to 3.5% (below estimates of 3.6%) and the labor force participation rate reaching a new cyclical high of 62.6% vs. 62.5%. Wage growth continues to rise at a pace incompatible with a 2% inflation rate.
The overall CPI becomes less important
For March, the CPI is forecast to rise 0.2% month-over-month and 5.1% year-over-year, which is slower than February’s reading of 0.4 % and 6.0%, respectively. Meanwhile, core CPI is expected to rise 0.4% month-over-month and 5.6% year-over-year. In February, the core CPI increased by 0.5% and 5.5%. If the core CPI increases by 5.6%, it will be the first time since September that it has increased and the first time since the start of 2021 that the core CPI has increased faster than the headline CPI.
Meanwhile, the Cleveland Fed forecasts a core CPI increase of 5.7%, slightly above analysts’ median estimate of 5.6%. Unfortunately, we cannot rely on inflation swap pricing this time as there is no pricing available for the base CPI, only for the headline CPI. The swap market suggests that headline CPI will rise 5.1%, in line with analysts’ expectations. However, based on these swaps, inflation is expected to rise in April, with year-over-year gains of 5.2%.
Odds rise for May rate hike
Given the strong March jobs report and the expected Core CPI report, the probability of a 25 basis point rate hike in May will likely increase further from the current 70% probability for the May meeting. Although a 25 basis point rate hike is much smaller than expected before the Silicon Valley Bank collapse, as stresses in the banking system ease, it could give the Fed more leeway. maneuvering to continue pushing rates higher beyond May.
The market had anticipated the growing odds of rate cuts in June. However, following the release of employment data, these probabilities have disappeared and no rate cut is now expected in June.
The recent stock market rally is exaggerated
The recent rally in tech and mega-cap stocks suggests that the stock market has priced in the rate cuts. If the data continues to support another rate hike in May and the possibility of no rate cut in 2023, then the recent rally in equities may be overdone and needs to be corrected. It is also possible that the nominal and real rates will start to rise again soon.
Additionally, despite the recent rally, NASDAQ earnings yields minus the 10-year TIP rate are still very low. This suggests that the NASDAQ remains overvalued relative to actual returns, more so than at any other time in the past decade.
It’s not just NASDAQ that’s overvalued relative to bonds. The S&P 500 dividend yield is also very low relative to the 10-year rate, and the spread between the two is trading at its highest level in more than a decade.
The stock market wants the Fed to finish with rate hikes and is betting that rates will start falling given the wide spreads and the recent rally in the NASDAQ and S&P 500. However, the data the Fed is focusing on, such as than employment data and inflation data, does not support the end of the cycle of Fed rate hikes or rate cuts.
On the other hand, survey data supports that the Fed is done with rate hikes and suggests that a substantial economic slowdown is underway. ISM manufacturing data fell to 46.3 in March, and such low levels tend to be associated with recessions. Meanwhile, the services survey showed the index fell to 51.2, near recessionary levels.
Moreover, it is now clear that the Fed is not conducting QE as the size of its balance sheet shrinks. This is because the use of the Fed’s discount window continues to decline and the pace of banks using the lending facility is slowing significantly.
Over the next two days, as the stock market continues to digest the fact that there is no QE and the Fed is likely to continue raising rates in May and potentially beyond, banking stress continues to ease and there is no rate cut. The recent NASDAQ rally will need to subside and the market will need to voice its opinion that the Fed needs to stop raising rates because weak data suggests the economy is slowing significantly.
Currently, the 10-2 spread in 18-month futures is increasing dramatically, and typically when this spread starts to increase, it goes out for the stock market.
Equities are not cheap and offer no earnings growth in 2023, while the outlook for 2024 is becoming increasingly fragile.