Multiple things can be true at once. Bear this in mind when trying to explain what just happened in world markets. Briefly, U.S. bond yields have surged to another new level, in response to data that suggest that inflation remains unbeaten. That’s led to a big re-evaluation of the prospects for monetary policy, with no conviction that rates will come down this side of November’s presidential election. Meanwhile, the stock market had a great week. The S&P 500 rallied 2.67%—its best performance since November.
How to reconcile this? Inflation isn’t great, but its market implications differ depending on the impact on economic growth. If it’s a symptom of an economy chugging along nicely, that implies getting out of bonds (whose returns are eaten away by price rises) and into stocks, whose earnings are helped by growth. If it combines with stagnation, then that’s stagflation, which is bad for more or less all financial assets.
So, investors are resigning themselves to a longer battle against inflation, while betting that the economy remains in good shape. Their evidence comes from the latest economic data, and from the first swathe of first-quarter earnings announcements. Judging by the market behavior, however, something more is afoot than a reaction to new evidence.
To start, last week’s biggest number was the first take on gross domestic product growth for the quarter, which also includes a measure of inflation. Growth fell very slightly, and below anticipation, while inflation was up, at a level unseen in some 30 years before the pandemic. Hence the surge in bond yields:
When a measure of inflation behaves like that, it’s far harder for a central banker to ease off, so there was (yet another) surge in bond yields and rate expectations. Then Friday brought the official personal consumption expenditures (PCE) inflation data for March. This matters, because it’s the Fed’s chosen target, and generally shows much lower inflation than the consumer price index (CPI) numbers. It came in very slightly above estimates gathered by Bloomberg, both month-on-month and year-on-year. That’s because core services prices (excluding housing), which tend to be sensitive to wage rises, are stubbornly continuing to inflate:
That sounds bad. But it could be worse. The Dallas Fed produces “trimmed mean” numbers for PCE, stripping out the main outliers and averaging the rest. The good news from this exercise is that it’s reducing—still a hair above 3%, which precludes rate cuts for now, but suggests disinflation continues, though slowly:
How did markets respond to somewhat disappointing news? By staging a rally. The numbers weren’t a major miss, and anxious whispers had suggested that it could be much higher. That’s good for risk assets. Such optimism also entails that financial conditions remain moderate, with equities not far from all-time highs and credit markets also strong. That leads to one of the strangest phenomena of the moment. The last time markets convinced themselves that rates would be “higher for longer,” back in October, broader financial conditions tightened considerably. This is exactly what would be expected. The whole point of keeping rates higher is to tighten conditions and slow down the economy a bit. Now, market expectations, as gauged by Bloomberg from fed funds futures, are much more downbeat about rate cuts, but this hasn’t moved financial conditions at all:
Implicitly, the Fed’s notorious “pivot” last year, when Chair Jerome Powell made clear that the bank wanted to cut rates and would do so before inflation was back down to its 2% target, remains in force in the market’s mind. Despite the disappointing inflation numbers—which might well be disappointing because of the way the Fed took off the pressure six months ago—the belief is that the “Fed Put” is in place. It’s not going to tighten more than it absolutely has to, and will be there to save the situation if things get bad.
Conditions are easy in large part because credit spreads—the extra yield over Treasuries that corporate bonds must pay to compensate for extra risk—›remain remarkably tight. As far as the credit market is concerned, there’s nothing to worry about. And that’s not what it was saying as inflation took hold in 2022, or even ahead of the pivot:
The calm credit markets have their own effect, making the financial environment easier and reducing perceptions of risk. Then comes last week’s other critical news—the first wave of first-quarter results, and particularly for four of the giant technology platforms collectively known as the Magnificent Seven. Overall, results season has been good so far. With 57% of S&P 500 members now having reported, earnings per share are 5% ahead of expectations, according to BofA Securities.
But it’s the Magnificent Seven that matter. Bloomberg’s earnings expectation service shows that blended forecast and actual first quarter earnings are 58.1% higher than at their nadir in November 2022. Meanwhile, the 493 companies in Bloomberg’s Large-Cap 500 Excluding Magnificent Seven index are on course to come in 8.4% below the estimate from that same date. So if you’re wondering why market watchers seem obsessed by just those seven stocks, that would be one reason:
Ed Clissold, chief U.S. equity strategist at Ned Davis Research, points out that Magnificent outperformance has been supported by fundamentals, with the Seven’s earnings rising by 11.8% while earnings for the rest of the S&P 500 fell 3.2%. He expects that gap to widen in the next four quarters. Consensus estimates, he says, call for the Mag 7’s earnings to soar 36.9% in 2024 versus 1.0% for the other 493 companies.
That is very deep reliance on a small group of companies, all of which are well-entrenched but vulnerable in various ways to changing political currents. The four to have reported so far include Microsoft Corp. and Alphabet Inc. (ahead of expectations and rewarded with a big rise in the share prices), Tesla Inc. (disappointing, but the market rallied anyway), and Meta Platforms Inc. (punished for missing expectations). How sustainable are these earnings, and to what extent are they being made at the direct expense of other large companies? Increased revenue for a chipmaker like Nvidia Corp., for example, is a big rise in capital expenditure for someone else. Meanwhile, price action in these seven firms over the last two weeks has been phenomenal. Even Nvidia, which hasn’t reported yet, dropped more than 15% before making most of it back:
Companies of this scale simply shouldn’t move so much, in either direction. The money involved is staggering; Alphabet gained $197 billion on Friday, after its earnings, while Nvidia shed even more than that the previous Friday, a day when it had no news. It’s good that some of the moves were up rather than down, but such market behavior demands an explanation. It’s hard to find one. Peter Tchir of Academy Securities explains his anxiety in a passage worth quoting at length:
Four ‘megacap’ companies moved around 10% (or more) in a day! I understand small cap companies do that. I understand that periodically something happens that is highly unusual… This was ‘just’ earnings. Maybe I’m being overly dramatic? Maybe I haven’t adjusted my thought process to how large companies really are (probably part of the issue)? In any case, it feels completely strange (even unnatural) for such large companies to move so much in a single session (let alone seeing it occur four times in six days)! I am willing to believe that this is just my perception, and maybe it is more common than I perceive, but it is so different than how I’ve been thinking, that I have to respect it.
The rebound in stocks, when there would have been ample justification to keep selling, suggests that there may not be enough bearish sentiment to take the selloff further. For the longer term, the extreme reliance on a few monopolistic platforms is disquieting.
What Next for the Yen?
The Japanese yen simply cannot catch a break. After it weakened in the wake of March’s exit from negative interest rates, it was thought to be just a matter of time before the Ministry of Finance would intervene to prop it up. Verbal cautions from currency officials didn’t create any respite and USD/JPY 152, a level that triggered intervention in the past, was expected to force action. But 152 came and went with officials remaining on the sidelines.
Sticky inflation in the U.S., and reduced rate cut expectations, have been a catalyst. At home, the Bank of Japan's dovish decision last week to keep lending rates unchanged at 0% to 0.1% saw the yen collapse to new lows, breaking into the 156 region. That selloff gathered more pace in early Monday trading, with the yen very briefly passing the 160 level. At the time of writing, it’s above 159:
Authorities appear now to be analyzing the yen in the broader context of the economy. When BOJ Governor Kazuo Ueda was asked about a possible intervention, he said that the yen's weakness hasn’t significantly impacted underlying inflation. If inflation were truly to take off, then much higher rates should bolster the currency.
Market intervention is costly. The government spent about $60 billion on it in 2022. Any such move now may cost more, and still be hostage to U.S. rates. TS Lombard’s Konstantinos Venetis argues that officials are cautiously picking their battles so the market won’t test their resolve, “trapping” them in a game currently dictated by U.S. bond yields.
However, the yen’s real buying power is stunningly weak, as is clear from looking at gold’s price in yen:
From this point onward, the yen’s path is likely to pique the interest of investors and policymakers. Societe Generale’s Kit Juckes suggests the beleaguered currency should soon find a floor, as different estimates of purchasing-power parity show it to be already far too cheap, somewhere in the mid-90s, or still around 110 if adjusted for market perceptions in Japan and the U.S.:
As long as yield differentials are large and growing, upward pressure on USD/JPY persists, and while an eventual return to much lower levels is inevitable, the danger here is that unless Japan’s policymakers are much more aggressive (with intervention and monetary policy), this move higher in USD/JPY will end in a final excessive spike higher.
Nonetheless, the cherry blossom season is here and the tourism sector is booming. Also, a weaker currency adds to exporters’ competitiveness. Analysts at Deutsche Bank argue that the $20 trillion carry trade, a key driver in the yen’s weakness, generates investment gains for the wealthy voting base that will make it politically difficult to prop the currency up:
Time will tell if the BOJ is moving too slow and generating a policy mistake. A shift in BOJ inflation forecasts to well above 2% over their forecast horizon would be the clearest signal of a shift in reaction function. But this isn’t happening now. The Japanese are enjoying the ride.
None of this rules out an intervention, particularly at such a point as officials have to confront the round number of Y160. But it looks ever more as though there is no specific ceiling that could trigger one. Ultimately, Japanese officials must be praying for a return to rate cuts optimism in the U.S.—without that, a costly intervention is still on the cards.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator at the Financial Times, he is author of The Fearful Rise of Markets.