U.S. equities are paring earlier gains even as Treasury yields continue to fall amid signs of slowing inflation. Still, investors are becoming increasingly cautious about what lower inflation means for growth.
Inflation continues to show signs of slowing in what could now be considered the “be careful what you wish for” category.
The good news is that the latest update to the third quarter Gross Domestic Product (GDP) report indicates that real growth in the economy accelerated to 5.2%. In addition, the pace of core personal consumption expenditures (PCE) inflation for the same period was revised to 2.3% from the previously reported 2.4%.
Better growth and lower inflation is a Goldilocks environment for equities; however, the Q3 GDP report is now well in the rearview mirror and investors are now focusing on the implications of the report and the recent run of soft US economic data for Q4 GDP growth, which is simply not as favorable.
In fact, U.S. economists are lowering their 4Q23 GDP growth forecast after the latest October trade and inventory reports — also released overnight — came to light, and gross domestic income rose only 1.5% in 3Q — well below the pace of GDP.
The slowdown in inflation may be indicative of a broader trend – a potential slowdown in demand for the goods and services that fueled the post-pandemic economic surge. While markets have been particularly nervous about runaway inflation for much of this year, they may be beginning to shift their concerns to slowing growth.
In the context of declining inflation and the possibility of slowing economic growth, yields on 10-year US Treasuries fell another 8 basis points to 4.27%. This was indeed a notable retreat, especially considering that yields started the month at a higher level of 4.90%, indicating a significant dovish sequence of events in a relatively short period of time.
Given the momentum behind the bond rally, it was doubtful that an upward revision to Q3 US GDP data would move the macro policy needle any further, especially when it was completely overshadowed by a slight downward revision to the core PCE price index (to 2.3% from 2.4%).
What mattered to traders were the downward revisions to the personal spending print and the slight downward revision to the core PCE reading. As mentioned above, complementing the bullish interest rate adjustment, October’s wholesale inventories and trade print was a notable miss. That’s going to weigh on Q4 growth estimates.
All that matters now is Chris Waller’s introduction of a tentative timeline for insurance cuts, contingent on the evolution of inflation numbers, and his rather blunt remarks about the likelihood that policy settings are now restrictive enough to bring inflation back to target.
Waller cemented one of the best runs for bonds since the financial crisis, and for this narrative to change it would likely require a string of robust economic data for the current quarter or a forceful hawkish stance from other influential Fed officials. As it stands, the overall market sentiment has shifted significantly in favor of dovish expectations this month.
If you’ve been in this game long enough, you know that it’s hard to overstate the importance of a surprising and apparent shift in tone from the Fed regarding the prospects for rate cuts in 2024.
To be sure, so-called “insurance cuts” have always been on the table, and officials have made no secret of it, so 50bp in 2024 was always a given.
So the idea of risk management cuts certainly isn’t new. Still, Chris Waller’s comments on Tuesday were the clearest indication yet that the Fed will be inclined to cut if inflation continues to fall, regardless of whether the broader economy is struggling. So, rate cuts without a recession, but now that the data is softening, another 50 or even 100, beyond insurance cuts, should not be considered out of reach. Investors are worried, however, about what’s driving these cuts beyond the risk-management insurance level, where the prospect of a recession in the next 12 months doesn’t seem too far-fetched.