David’s Market Update – August
Wednesday’s inflation data (CPI) provided the first signs that inflation may have peaked. Month over month core inflation was unchanged for the month versus last month’s increase of 1.3%. On an annualized basis, CPI rose by 8.5% compared to last month’s 9.1%. One month’s worth of data, of course, does not establish a trend so in the coming months we will need to see similar declines before drawing any conclusions as that relates to FED policy. Given recent sharp declines in a multitude of commodities (oil, copper, lumber, CRB Index etc.) I suspect that Thursday’s release of the PPI Index may show an even more profound decline.
In any event, initial market reaction to the report has been extremely favorable for both stocks and bonds. The DOW Jones is currently higher by more than 500 points while bond yields have also declined sharply. More notably, the biggest declines in yields are occurring at the shorter end of the yield curve causing the yield curve to steepen. As of Tuesday, the yield curve between 2 year treasuries and 10 year treasuries had been inverted by nearly 50 basis points. Something not seen an many years.
With today’s reaction, that curve is now inverted by about 38 basis points. Still an ominous sign and still very inverted. With 4 rate hikes in the books so far this year we are now much closer to the terminal Federal Funds rate than we were 6 months ago. This leaves less room for rates to rise and more room for rates to decline as we get closer to that terminal rate.
Even though consensus is nearly unanimous that the FED will raise short rates again at the next meeting, whether it be by 50 or 75 basis points, the fact that short rates, even with the recent declines, are still generally above 3.00% suggests that the market has almost fully discounted the next 1 or 2 rate hikes. Therefore, those investors waiting for future rate hikes in order to invest in bonds will likely be disappointed as market reaction “may” be similar as before; that is lower yields, not higher.
For context; when the FED executed its 1st 75 basis point rate hike in mid-June, the yield on 10 treasuries stood at just under 3.50%. Today, after 150 basis points of rate hikes (2 x 75 bp’s) the 10 year treasury yield sits at 2.72%. Market timing is and remains an exercise in futility in my opinion.
The VIX Index has been in a recent steady decline which should bode well for stocks. Even the MOVE Index (the bond market equivalent of the VIX) although still elevated, is showing signs of trending lower.
Although the CPI data is welcome news it is by no means the “all clear sign” for recent market turbulence. Risks remain and investors should stick with their long-term goals.
My outlook for rates has not changed as I expect 10 year yields to meander in the 2.50% – 3.25% range as well as I expect that municipal bonds will continue to outperform taxable bonds given the persistent limited supply and ongoing prospects for higher tax rates. Anytime you can buy a high quality tax-free bond whereby the absolute yield of the muni bond exceeds that of the taxable alternative and the “muni ratio” exceeds 100%, you are making a good purchase. Those opportunities are still present even with recent yield declines.
Source: Bloomberg
