Morning Report: The market makes a dramatic shift in interest rate forecasts

Vital Statistics:

S&P futures3,76919.25
Oil (WTI)123.012.24
10 year government bond yield 3.34%
30 year fixed rate mortgage 5.94%

Stocks are higher this morning after yesterday’s bloodbath. Bonds and MBS are up small.

Yesterday’s market sell-off took the S&P 500 into bear market territory, which is defined as 20% from the peak. What caused the stock market to sell off so dramatically? The answer is that the markets reassessed their forecast for this week’s FOMC meeting. The Fed Funds futures went from forecasting a 50 basis point tomorrow to a 75 basis point hike. Take a look at the Fed Funds futures chart below:

Last week, the Fed Funds futures were predicting a 96% chance for a 50 basis point hike. They are now predicting a 94% chance of a 75 basis point hike. This is all in reaction to the overly-hot CPI number on Friday.

One other market observation is this reassessment of Fed policy has flattened the yield curve. The yield curve is basically a plot of the interest rate at different maturities. Typically, the yield curve slopes upwards, which means that investors require a higher interest rate for longer maturities than shorter ones. That is no longer the case in any meaningful way. The 2 year bond yield is 3.33%, while the 10 year is 3.35%. The difference is a mere 2 basis points. A year ago, that difference was 2% or 200 basis points. The black line in the chart below is what the curve looked like a year ago. The blue line is what it looks like today.

If long term rates fall below short term rates (in other words, a yield curve inversion), that often forecasts a recession. Note that the shape of the yield curve means a lot less in a QE world, but historically that has been a decent economic signal. That is what stocks are reacting to.

Inflation at the wholesale level rose 0.8% MOM in May, according to BLS. On an annual basis, prices rose 10.8%. Ex-food and energy, prices rose 0.5% MOM and 6.8% YOY. These numbers were a tough below Street expectations, but probably won’t make a difference as far as Fed policy is concerned.

Small business optimism is under pressure, according to the NFIB small Business Optimism Survey. Expectations about the future are downright awful, and the expectations index is at a record low. This is being driven by inflation, a tight labor market, and continued supply chain issues. The thick line in the chart below shows whether businesses think this is a good time to expand. The thin line shows expectations for the future.

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