Will the stock market rally turn into a sell-off? This Bond Market Indicator Could Alert Investors

Now that the Federal Reserve appears to have abandoned your forward facing tool In favor of being “data dependent” to help inform their future path for rates, investors should keep an eye on this gauge of inflation expectations for signs of a change in market sentiment.

Look at the five-year breakeven rate of inflation, one of the most reliable indicators of inflation expectations, to help gauge the direction of Federal Reserve monetary policy, a team of macro strategists at Jefferies Group JEF,
+0.21%
said.

The five-year breakeven rate has helped predict the direction of stocks throughout the year, and could very well offer clues as to where stocks will head next, the team said.

The five-year breakeven rate represents the difference in yields between the nominal five-year Treasury note TMUBMUSD05Y,
2.658%,
and five-year Treasury Inflation-Protected Securities Note 9128286N55,
-0.157%.
Bond yields rise when prices fall.

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

After rising sharply in the first half of the year as inflation expectations soared and US stocks tumbled, the five-year breakeven rate pulled back sharply in late June and early July, and finally it hit its lowest level of 2022 on July 6, when it broke below 2.5%, according to data from the St. Louis Fed.

Source: St. Louis Federal Reserve

This recent decline, which coincided with the drop in commodity prices and Treasury yields, appears to have preceded the latest bull run for stocks. In July, the S&P 500 SPX,
-0.28%,
Dow Jones Industrial Average DJIA,
-0.14%
and Nasdaq Composite COMP,
-0.18%
each consolidated their best month in about two years, with the Nasdaq rising more than 12%.

David Zervos, chief market strategist at Jefferies, said he expects the rally in stocks to continue in the coming days and weeks, but will closely monitor the five-year breakeven rate and economic data, in a Sunday note to investors. customers. .

“…[W]we wait [Fed Chairman] Jay [Powell] You will look very closely at how inflation expectations respond to this substantial change in the overall policy stance/guidance. So if inflation break-even points or inflation expectations survey data start to rise, we’ll quickly see a change in tone from Jay,” Zervos said.

Measure a Fed Pivot

The recent pullback in inflation expectations has led fed funds futures traders to anticipate that the policy rate will peak at 3.50% later this year, followed by rate cuts starting next spring, according to CME’s FedWatch tool.

In response, economists at Deutsche Bank and Goldman Sachs analysts have questioned whether investors have become too optimistic about potential rate cuts next year. So far, however, US stocks seem to have shrugged off those concerns.

Looking ahead, investors will likely need to see a substantial change in inflation expectations, or a serious deterioration in the strength of the labor market and the underlying economy, to spark another round of strong equity selling, the research team wrote. Jefferies.

Because of this, the five-year breakeven rate will be “the key metric to watch to confirm the pivot” for both the Fed and stocks, Zervos said.

The Fed still wants 2% inflation

Fed Chairman Powell has repeatedly stressed the importance of inflation expectations in post-meeting press conferences. On Wednesday, he reiterated that the Fed aims to “reduce inflation to our 2 percent target and keep long-term inflation expectations well-anchored.”

US inflation remained at a maximum of 40 years until the end of Junee, according to the latest reading of the personal consumption price index, which was released days after the Fed’s rate hike last week. A day later, 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 tipped into a recession.

Read: Is the United States in a recession now? Not yet, and here’s why

Market-based indicators have been especially helpful at a time when the Fed has all but abandoned forward guidance, leaving investors to sift through mixed messages from Powell and other Fed members.

Many equity strategists have applauded the prospect of a Fed pivot, or a move away from aggressive rate hikes, later this year. But Minneapolis Fed President Neel Kashkari said in recent days the new york times Y CBS News that the Fed is still “very far” from backing down in its fight against inflation.

On Monday, Bloomberg news published an editorial written by former New York Fed President Bill Dudley, who criticized investors’ “wishful thinking” about a Fed pivot as “unfounded and counterproductive.”

From a purely technical standpoint, some market technicians expect stocks to be poised for further gains, after retracing nearly half of their year-to-date losses.

For the S&P 500, the next key resistance level would be 4178, according to John Kosar, chief market technician at Asbury Research. If the US benchmark index trades above that level for at least several sessions, the next key resistance level would be between 4279 and 4346. The next key “support” level for the S&P 500, should going back, it would be between 3922 and 3946.

Read: US stocks struggle to find direction after best month for S&P 500 and Dow since November 2020

US stocks lost control of modest gains on Monday afternoon. The benchmark index fell 0.4% to around 4,105, while the Nasdaq Composite fell 0.5% to around 12,316 in afternoon trading. The Dow Jones Industrial Average was down 0.4% near 32,698.

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