QQQ - The Cure For Rising Rates Is Rising Rates

2023-10-03 11:20:57 ET

Summary

• S&P 500 gains have been driven by mega-cap tech stocks, while most stocks declined due to rising interest rates.
• Fed officials discuss the need for higher rates, despite low inflation and economic resilience.
• Manufacturing sector shows signs of expansion, construction spending rises, but long-term bond yields increase due to fear of insufficient demand.

It was an extremely volatile first day of trading for the fourth quarter. While we squeaked out a small gain for the S&P 500 (SP500), it was fueled predominantly by the mega-cap technology names that have led the market higher year to date. That is not healthy. Most stocks declined, as we saw new highs in long-term interest rates with the 10-year Treasury yield piercing 4.7%. The excitement over a last-minute deal to avoid shutting down the federal government on Sunday night faded quickly, as investors refocused on the impact of rising short- and long-term interest rates.

Fed officials can’t seem to stop talking about how rates may need to stay higher for longer, and some insist we need to increase the Fed funds rate multiple times to bring inflation down to target. Yesterday, Fed Governor Michelle Bowman insisted that more than one hike may be needed to achieve stable prices, considering that the increase in energy prices could “reverse some of the progress” the Fed has made in recent months. I can only assume that Ms. Bowman, an attorney by trade, didn’t have a chance to review last week’s core PCE report, which showed just a 0.1% monthly increase for August. That came despite a 35% rise in the price of oil over the prior four months.

Bowman also failed to acknowledge that the Fed does not focus on food and energy prices because of their volatility and the limited impact monetary policy has on both. Her rhetoric on Monday helped propel rates higher across the curve, which was music to the ears of billionaire investor Bill Ackman, who has been promoting his outsized short position in long-term Treasuries in the financial media the past few weeks.

Cleveland Fed President Loretta Mester, who is not a voting member of the FOMC, also suggested that we need one more rate hike this year to bring inflation back down to 2%. I find it stunning that investors place so much weight on what these people say when they were completely blind to the coming surge in prices two years ago. I suppose it makes sense to assume they would be just as blind to how quickly prices can fall.

No matter how many billionaires attempt to talk rates higher for self-aggrandizement, and no matter how often Fed officials express overly hawkish outlooks for monetary policy, it does not change the incoming data. To date, it shows disinflation alongside economic resilience. Last week we learned that disinflation remains well entrenched. Yesterday, we saw more economic resilience.

ISM’s Manufacturing index ((PMI)) rose for a third month in row to the level of 49 (50 marks the line of demarcation between growth and contraction), which was well above expectations of 47.8. The sector is on the verge of expanding again after eleven months of contraction. This is another positive rate of change that could not be timelier, as the services sector of the economy, while still growing, is starting to slow. The production sub-index increased to 52.5% and was positive for a second month in a row. The employment index moved back into expansion at 51.2%. Best of all, the prices index plummeted to 43.6%, which reinforces the disinflation we have seen in the PCE and CPI.

Furthermore, construction spending rose 0.5% in August over the previous month, and the July increase was revised up from 0.7% to 0.9%. Overall construction spending has risen 7.4% over the past year. The strength is balanced between public and private. This is another positive rate of change that does not suggest we are on the cusp of an economic downturn.

The recent rise in long-term bond yields, which has driven the 10-year Treasury yield (US10Y) to 4.74% this morning, is not consistent with the disinflationary trend, the slowing rate of economic growth, or depressed commodity prices. It clearly has everything to do with the fear that the increase in supply to fund growing deficits will not be met with sufficient demand. That has traders shorting long-term bonds, accelerating the drop in prices and rise in yields, in a self-fulfilling prophecy.

The only good news here is that the best cure for high interest rates is high interest rates. Much as we have seen in the price of oil, higher prices depress demand, which leads to lower prices. At some point higher interest rates start to fuel concerns about much slower growth, which then leads to demand for bonds that drive yields back down. I think we are close to that point. The debate will be whether this process leads to an economic contraction or not. I still think we avoid one because corporations and consumers are far less sensitive to rising rates today than they have been in previous business cycles.

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