No, It’s Not Earnings Driving US Stocks…

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No, It’s Not Earnings Driving US Stocks…

Fed Funds Futures markets are on the move, becoming much more dovish over the last week. The most recent data (link at the end of this section to the CME FedWatch tool):

  • June FOMC meeting expectations: the odds of a rate cut have increased from 10% to 24% in the last week.
  • July meeting: odds that Fed Funds are lower than today are up to 33% from 14% a week ago. Worth noting: this is the most active contract.
  • September meeting: futures give essentially even odds (53/47) that the Fed will either cut rates at that meeting or has already done so. A week ago, the odds that Fed Funds would be the same as now were 74%.
  • December meeting: futures now put 62% odds the Fed will have cut rates in 2019, up from 42% a week ago.

So what has happened in the last week that might be pushing Fed Funds Futures to think a rate cut is coming? A few thoughts:

  • As Jessica noted in her Beige Book write-up last week, three FOMC voting members (Bullard, Rosengren, Evans and Harker as an alternate) have all been sounding cautious notes about rate policy.
  • There is clearly some concern at the Fed that core inflation remains below the central bank’s 2% target rate, meaning that monetary policy is currently too restrictive. The Wall Street Journal outlined this case in an article published Saturday (link at the end of this section).
  • While President Trump’s recent Fed board nominees may have hit the shoals, it is clear he wants candidates who favor lower interest rates. All the Fed’s Board of Governors have a vote on policy, unlike the regional presidents who rotate through the FOMC.

The important point to all this: Fed Fund Futures are responding to shifts in FOMC communication/committee structure, not because the US economy is weakening, and that is helpful to US equity valuations and market sentiment for the following reasons:

#1: It has capped – for the moment, at least – any move higher for US 10-year Treasury yields.

  • After hitting a 2019 low yield of 2.37% on March 27th, 10-year yields rose quickly through the first half of April to a high of 2.59% on the 16th.
  • With the Fed Fund Future’s reassessment of central bank policy over the last week, 10-year yields have fallen to 2.52%.

#2: Two-year Treasury yields have actually responded more than 10-years, which means the yield curve had steepened modestly:

  • Recent trading action in 2-years mirrors the 10-year: a 2019 low point on March 27th (2.21%) and a bounce through April 16th (2.41%).
  • Over the last week, 2-year yields have fallen by 9 basis points to 2.32%.
  • That puts the current 2-10 year Treasury spread at 20 basis points, better than the 18 basis points of last week. As this is a closely watched recession indicator, that increase is a modest positive.

The upshot here in terms of US equity valuations is clear enough: lower rates without the fear of a recession are basically a gift for domestic stocks. Here’s why:

  • The last time the S&P 500 was +2920 was in late September/early October. Earnings expectations for the index in 2019 were $178/share back then, and the 10-year yielded 3.20%.
  • Now, we are in basically the same spot on the S&P at 2930, but 2019 earnings expectations are $168/share (6% lower than the previous point) and the 10-year yield is 2.5% (22% lower).

Bottom line: we think this shift in market expectations for Fed policy is at least as important to the recent run-up in US stocks as better-than-expected earnings reports.

Sources:

Wall Street Journal article: https://www.wsj.com/articles/fed-officials-contemplate-thresholds-for-rate-cuts-11555758001

Fed Funds Futures odds: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html