Will the stock market rally turn into a selloff? This bond market indicator could tip investors

Now that the Federal Reserve appears to have ditched its forward-looking guidance tool in favor of being “data dependent” to help inform its future rate path, investors should keep an eye on this indicator of inflation expectations for investors. signs of a change in market mood.

Look at the five-year break-even inflation rate, one of the most reliable indicators of inflation expectations, to help gauge the direction of the Fed’s monetary policy, a team of macro strategists from Jefferies Group JEF,
+ 0.21%
She said.

The five-year break-even rate helped predict the direction of the stocks throughout the year and could very well offer clues as to where the stocks might be headed next, the team said.

The five-year break-even rate represents the difference in yield between the five-year nominal Treasury bond TMUBMUSD05Y,
2.650%,
and the five-year note on Treasury inflation-protected securities 9128286N55,
-0.183%.
Bond yields rise when prices fall.

According to the Federal Reserve Bank of St. Louis, this spread represents the premium demanded by holders of inflation-protected securities, making it an effective proxy for market expectations of the average rate of inflation over the next five years.

After a sharp rise in the first half of the year due to soaring inflation expectations and the collapse of US equities, the five-year break-even rate declined sharply in late June and early July, eventually reaching its lowest level in 2022. July 6, when it fell below 2.5%, according to data from the St. Louis Fed.

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        Source: St. Louis Fed
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   This recent decline, which coincided with the decline in commodity prices and Treasury yields, appears to have preceded the last rally in equities.  In July, the S&P 500 SPX,
    <bg-quote field="percentchange" format="0,000.00%" channel="/zigman2/quotes/210599714/realtime" class="negative">-0.28%</bg-quote><span>,</span>
   Dow Jones Industrial Average DJIA,
    <bg-quote field="percentchange" format="0,000.00%" channel="/zigman2/quotes/210598065/realtime" class="negative">-0.14%</bg-quote>
   and Nasdaq Composite COMP,
    <bg-quote field="percentchange" format="0,000.00%" channel="/zigman2/quotes/210598365/realtime" class="negative">-0.18%</bg-quote>
   each cemented their best month in about two years, with the Nasdaq up more than 12%. </p> <p>David Zervos, Jefferies' chief market strategist, said he expects the equity rally to continue in the coming days and weeks, but will closely track the five-year break-even rate and economic data, in a Sunday note to clients.</p> <p>"...[W]and I expect [Fed Chairman] Jay [Powell] he will be watching very carefully how inflation expectations respond to this substantial change in the general orientation of the policy / guide.  So if inflation breaks even or the poll data on inflation expectations starts to rise, we will quickly see a change in Jay's tone, ”Zervos noted.</p><h6>Measuring a Fed pivot</h6> <p>The recent decline in inflation expectations has prompted Fed funds futures traders to anticipate that the policy rate will peak at 3.50% by the end of the year, followed by rate cuts as early as next spring, according to the tool. FedWatch of the CME. </p> <p>In response, Deutsche Bank economists and Goldman Sachs analysts questioned whether investors have gotten too optimistic about potential rate cuts next year.  So far, however, US stocks appear to have ignored these concerns.</p> <p>Looking ahead, investors should likely see a substantial shift in inflation expectations, or a severe deterioration in the strength of the labor market and the underlying economy, to trigger another round of sharp stock selling, the Jefferies team wrote. .</p> <p>For this reason, the five-year break-even rate will be "the key metric to watch for confirming the pivot" for both the Fed and equities, Zervos said.</p><h6>The Fed still wants 2% inflation.</h6> <p>Fed Chairman Powell has repeatedly stressed the importance of inflation expectations in post-meeting press briefings.  On Wednesday, he reiterated that the Fed aims to "bring inflation back to our 2% target and keep long-term inflation expectations well anchored."</p> <p>US inflation remained at a 40-year high through the end of June, according to the latest reading from the Personal Consumer Price Index, which was released just days after the Fed's rate hike last week.  The next day, second quarter gross domestic product data confirmed that the US economy contracted again in the second quarter, sparking further debate over whether the US economy has already entered recession. </p> <p><strong>Laws:</strong> Is the US in a recession now?  Not yet - and here's why</p> <p>Market-based indicators have been particularly useful at a time when the Fed has almost abandoned forward guidance, leaving investors to analyze the conflicting messages from Powell and other Fed insiders. </p> <p>Many equity strategists hailed the prospect of a Fed pivot, or a move away from aggressive rate hikes, by the end of the year.  But Minneapolis Fed Chairman Neel Kashkari told the New York Times and CBS News in recent days that the Fed is "very far" from backing down in its fight against inflation. </p> <p>On Monday, Bloomberg News ran an editorial written by former New York Fed Chairman Bill Dudley, who criticized investor "wishful thinking" about a Fed pivot as "groundless and counterproductive."</p> <p>From a purely technical standpoint, some market technicians expect the stocks to be ready for a further upside, having retraced nearly half of their losses since the beginning of the year.</p> <p>For the S&P 500, the next key resistance level would be 4,178, according to John Kosar, chief market technician at Asbury Research.  If the US benchmark were to trade above that level for at least several sessions, the next key resistance level would be between 4,279 and 4,346.  The next key level of "support" for the S&P 500, if it were to retreat, would be between 3,922 and 3,946. </p> <p><strong>Laws: </strong>US stocks struggle for direction after best month for the S&P 500, Dow since November 2020</p> <p>US equities lost their grip on modest gains on Monday afternoon.  The benchmark fell 0.4% to around 4,105, while the Nasdaq Composite fell 0.5% to close to 12,316 in afternoon trading.  The Dow Jones Industrial Average fell 0.4% to close to 32,698.


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