Now that the Federal Reserve seems to have given up its foresight tool in favor of being “data dependent” to help inform its future path for rates, investors should keep an eye on this gauge of inflation expectations for signs of a shift in market sentiment.
Watch the five-year breakeven inflation rate, one of the most reliable indicators of inflation expectations, to help gauge the monetary policy stance of the Fed, a team of macro strategists at Jefferies Group
The five-year break-even rate has helped predict the direction of stocks throughout the year, and it could very well offer clues as to where stocks might go next, the team said.
The five-year equilibrium rate represents the difference in yield between the nominal five-year Treasury bill
and the five-year inflation-protected treasury bill
Bond yields rise as prices fall.
According Federal Reserve Bank of St. Louisthis spread represents the premium demanded by holders of inflation-protected securities, making it an effective approximation of market expectations for the average rate of inflation over the next five years.
After rising sharply in the first half of the year as inflation expectations soared and US equities plunged, the five-year equilibrium rate fell sharply in late June and early July, eventually bottoming out. 2022 level on July 6, when it fell below. 2.5%, according to data from the St. Louis Fed.
This recent drop, which coincided with falling commodity prices and Treasury yields, appears to have predated the final leg higher in stocks. In July, the S&P 500
Dow Jones Industrial Average
and compound Nasdaq
each cemented their best month in about two years, with the Nasdaq jumping more than 12%.
David Zervos, chief market strategist at Jefferies, said he expects the rally in equities to continue in the days and weeks ahead, but will closely monitor the breakeven rate on five years and economic data, in a Sunday note to clients. .
“…[W]I expect to [Fed Chairman] Jay [Powell] will monitor very carefully how inflation expectations react to this substantial change in the general policy stance/guidance. So if inflation breakevens or inflation expectations survey data start to jump, we’ll quickly see a change in Jay’s tone,” Zervos noted.
Measuring a Fed Pivot
The recent decline in inflation expectations has prompted fed funds futures traders to anticipate the benchmark rate to peak at 3.50% later this year, followed by rate cuts as early as next spring, according to CME’s FedWatch tool.
In response, economists at Deutsche Bank and analysts at Goldman Sachs wondered if investors had become too optimistic about potential rate cuts next year. So far, however, US equities appear to have ignored these concerns.
Going forward, investors would likely need a substantial change in inflation expectations, or a serious deterioration in the strength of the labor market and the underlying economy, to trigger another round of strong stock sales, the Jefferies team wrote.
For that reason, the five-year equilibrium rate will be “the key metric to watch to confirm the pivot” for both the Fed and equities, Zervos said.
The Fed still wants 2% inflation
Fed Chairman Powell repeatedly stressed the importance of inflation expectations in post-meeting press briefings. On Wednesday, he reiterated that the Fed aims “to get inflation back to our 2% target and keep long-term inflation expectations well anchored.”
US inflation remained at a 40-year high through the end of Junee, according to the latest reading of the Personal Consumer 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 U.S. economy had contracted again in the second quarter, sparking more debate about whether the U.S. economy had already tipped into a recession.
Market-based indicators have been particularly helpful at a time when the Fed has all but abandoned forward guidance, leaving investors to parse mixed messages from Powell and other Fed insiders.
Many stock market strategists cheered the prospect of a Fed pivot, or exit from aggressive rate hikes, later this year. But Minneapolis Fed President Neel Kashkari said in recent days the New York Times and CBS News that the Fed remains “far far” from backing down in its fight against inflation.
On Monday, Bloomberg News Released an op-ed by former New York Fed Chairman Bill Dudley that criticized investors’ “wishful thinking” about a Fed pivot as “both unfounded and counterproductive.”
From a purely technical standpoint, some market technicians expect stocks to be poised for further gains, having retraced nearly half of their year-to-date losses.
For the S&P 500, the next key resistance level would be 4,178, according to John Kosar, chief market technician at Asbury Research. Should the US benchmark trade above this level for at least several sessions, the next key resistance level would be seen between 4,279 and 4,346. The next key “support” level for the S&P 500, s should it pull back, would be between 3,922 and 3,946.
US stocks lost control of modest gains on Monday afternoon. The benchmark fell 0.4% to around 4,105, while the Nasdaq Composite was down 0.5% near 12,316 in afternoon trading. The Dow Jones Industrial Average was down 0.4% near 32,698.