When Federal Reserve (Fed) Chair Powell mentioned the U.S. economy may be entering a “new normal” on Friday, the S&P 500® fell -0.5% in just five minutes. The index was able to regain lost ground once investors realized he was referring to the labor market, and not the current bear market. Nevertheless, the index closed far below the prior day. Investors should expect more forward guidance this week, with 22 Fed speeches scheduled, including two from Chair Powell. It will be a week full of economic reports, but there are two we will be watching most closely: GDP revisions, which may turn growth rates positive from earlier in the year, and the Personal Consumption Expenditure (PCE) report, which is the Fed’s preferred measure of inflation. Given Chair Powell specifically noted he is watching the core PCE 3-, 6- and 12-month moving averages, we expect investors will be watching Friday’s PCE report with much anticipation.
Domestic equities are less than 100 basis points (bps) from the lows of the year as the Fed continues to tighten financial conditions. The CBOE Volatility Index (VIX) saw a sharp move higher on Friday as economic data came in better than expected. The VIX now sits just below 30 (a level that implies +/- 2% price swings in the S&P 500), and its futures curve has shifted into backwardation as investors are again concerned over restrictive monetary policy.
As of this writing, Italian election results have yet to be finalized; however, it is widely expected that the far-right party, Brothers of Italy, will win the office of prime minister. With numerous unresolved headwinds impacting Europe, the MSCI World ex USA Index had its third-worst week of the year as the U.S. Dollar Index spiked to a new 20-year high.
With currency markets experiencing a negative impact from the Fed’s rate hike, the MSCI Emerging Markets Index had its worst week since mid-June despite outperforming its major peers on a relative basis. Headlines warn of the Chinese yuan crossing above 7.00 USD for the first time since 2020; however, a weaker currency may be beneficial for a net-exporter like China in the short-term.
Fixed Income Markets
Resistance going back to 2011 held, as the 10-year U.S. Treasury (UST) failed to break above 3.75% last week. As short-term interest rates rose more than long-term rates, the spread between the 10- and 2-year UST inverted to -53 bps, the lowest since 2000. However, the yield curve better aligned with the health of the U.S. economy, the 10-year to 3-month UST bill spread, steepened to 49 bps, indicating the business cycle is still in a slowing expansion phase.
Chart of the Week
Last week’s Federal Open Market Committee (FOMC) meeting led to a third consecutive rate hike of 75 bps, increasing the fed funds rate to 3.25%, the highest level since early 2008. Those expectations were already the consensus view heading into the FOMC meeting; however, the “dot plot” showing terminal rate expectations of each FOMC member jumped to a median level of 4.60%. In contrast, the market’s implied expectation was 4.25-4.50% earlier in the week, causing a negative market reaction as valuations had to adjust lower. Despite renewed concerns about a “hard landing,” high yield credit spreads are almost 100 bps below the highs of the year. The fact that economic activity is still growing at a time when monetary policy wants to restrict growth in order to bring down inflation is a challenge for investors.