Wall Street faces a fresh set of challenges next week as stocks cling to modest year-to-date gains and Treasury bonds yields test rate-cycle highs.
Federal Reserve Chairman Jerome Powell’s semi-annual testimony on Capitol Hill next week will highlight a crucial five-day period for stock markets as investors search for direction amid a surge in Treasury bond yields, a red-hot job market that continues to stoke inflation pressures and fading corporate profit outlooks tied to recession risk.
Powell, who will deliver the Fed’s ‘Semiannual Monetary Policy Report’ before the Senate Banking Committee on Tuesday, with a follow-up appearance before the House Financial Services Committee on Wednesday, will likely be grilled on his early-February assertion that “we’re in the very early stages of disinflation” when job growth, consumer spending, core inflation data and activity indices all suggest accelerating price pressures.
Since those statements, which followed the Fed’s last interest rate decision on February 1, the odds of a 50 basis point rate hike in March have risen to 27%, while the chance of a Fed Funds rate that exceeds 5.5% have surged to around 49%, according to the CME Group’s FedWatch.
Prior to that, traders were unwilling to wager anything on either outcome.
“The Federal Reserve is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials,” the central bank said in its March monetary policy summary. “The labor market has remained extremely tight, with job gains averaging 380,000 per month since the middle of last year and the unemployment rate remaining at historical lows.”
Benchmark 10-year Treasury note yields, meanwhile, have risen by more than 70 basis points, hitting a cycle-high of 4.09% in early Thursday dealing before paring that gain to around 4.01% on Friday. At the same time, 2-year note yields touched the highest levels since 2007 while the entire Treasury complex — from 1-month bills to 30-year bonds — traded north of 4%.
Rate Bets Hammer Stocks
The wholesale shift in rate and inflation prospects, powered in part by January’s blowout jobs number and a hotter-than-expected reading of the Fed’s preferred PCE price index gauge, has hammered stocks, sending the S&P 500 down nearly 4% from its February 2 peak.
Refinitiv data, in fact, shows that the value in holding stocks over bonds, measured by the difference between the S&P 500’s earnings yield and return from a benchmark 10-year Treasury bond, is the narrowest in nearly two decades.
Bank of America’s closely tracked Flow Show report noted another $7.4 billion pullback from U.S. equity funds, with around $8.4 billion finding its way into fixed income funds. Respondents also linked a 4% 10-year Treasury note yield with a 3,800 price target on the S&P 500, suggesting another 5.3% pullback from current levels if markets continue to price-in further Fed rate hikes.
Stocks aren’t likely to get much help from corporate earnings prospects, either, given that S&P 500 profits are expected to fall by around 4.3% from last year over the current quarter to a share-weighted $424.5 billion before rebounding modestly to a 5.7% growth rate over the three months ending in June.
The 4% level on 10-year bonds could be tested, in either direction, by data on Wednesday showing the number of unfilled positions in the U.S. economy over the month of January. The Job Openings and Labor Turnover Survey, known as JOLTs, hit a near record high of 11.01 million in December.
Another elevated reading could stoke worries that employees will need to either pay staff more to keep them in place or lift starting salaries in order to entice recalcitrant workers from the job market sidelines.
A surprisingly resilient job market, one of Powell’s chief concerns for several months, has shown further signs of strengthening lately with weekly applications for unemployment benefits falling for three consecutive weeks, while a detailed update of on so-called unit labor costs for U.S. companies over the three months ended in December surged 6.3% from last year.
Bond Auction: Focus On Foreign Buyers
“Labor demand in many parts of the economy exceeds the supply
of available workers, with the labor force participation rate essentially unchanged from one year ago,” the March Fed summary said. “Nominal wage gains slowed over the second half of 2022, but they remain above the pace consistent with 2% inflation over the longer term, given prevailing trends in productivity growth.”
A further test for Treasury yields — and by proxy stock prices — will come later in the Wednesday session with a $32 billion sale of re-opened 10-year notes, with traders closely watching the level of foreign investor interest.
Some analysts have suggested that 10-year Germany government bonds, trading at a multi-year highs of 2.74%, offer a competitive alternative while the Bank of Japan’s reported plans to widen the trading ‘band’ of Japanese government bonds could accelerate outflows from domestic fund managers – the largest foreign owners of U.S. debt in the world.
The week’s final, and likely most decisive event, falls on Friday with the release of the Labor Department’s February jobs report. Early indications suggest the economy added around 200,000 new positions last month, with average hourly earnings rising 4.8% on the year — and 0.3% from January — with a headline unemployment reading of 3.4%.