Happy Fed day to all who observe. S&P 500 and Nasdaq 100 futures are higher ahead of the US central bank’s decision, widely anticipated to be the first rate hike since July 2023.
Retail traders on Robinhood have stepped up their buys of single stocks ahead of the potential onset of a tightening cycle, with five-day net purchases running at their highest levels since June:
Crypto stocks looking for CLARITY failed to find it on Tuesday, as the Senate blocked consideration of legislation that industry executives and proponents had pushed for and helped shape. But it was a case of bill down, bulls up: Robinhood traders were buyers of crypto-linked stocks that sold off amid this news.
As a subsidiary of Robinhood, Sherwood Media is restricted from writing about any company in which Robinhood is or was a selling group member of the IPO during the regulatory "quiet period" for that company.
Longs need the long end
Prediction markets and short-term interest rate markets (the OG prediction markets) overwhelmingly expect the Federal Reserve to raise its policy rate today.
I’ll leave it to one of my favorite economists, Peter Williams of 22V research, to offer the quick-and-dirty on why:
“The labor market looks stable, and may arguably be starting to gradually improve, growth is solid-to-strong, the consumer has been remarkably robust, the AI boom rolls on, supply shocks continue hitting the global economy, and financial conditions remain easy overall. In this backdrop, the center of FOMC has gradually lost confidence that policy is at an appropriate stance to ensure disinflation back to target over an acceptable time horizon.”
For traders, “what” and “how much” the Fed will do, as ever, remain more valuable questions than why.
There’s a lot of debate among economists as to whether the so-called “dot plot” will signal that the Fed plans to hike rates once or twice more this year if things go loosely according to plan. Market pricing is currently for about 100 basis points of tightening between now and this time next year.
Per Goldman’s Ben Snider, having priced in this much tightening is “lifting the bar for policy to surprise in a hawkish direction.” He adds, sagely, that “The medium-term impact of Fed tightening on equities will depend on how tightening affects earnings growth, which is the most important driver of stocks.”
However, in the medium term you can also get stopped out of whatever you hoped would work in the near term. And in the near term, one of the factors that’s started to weigh on equity enthusiasm has been the steady march higher in bond yields, with the 10-year Treasury yield recently breaching 5%.
Bespoke Investment Group offers some great research showing that 5% is more than just a number for this maturity:
“On every trading day since 1962 when the 10-year yield traded with a 5-handle (10.5% of all occurrences), the S&P 500’s average three-month performance was a gain of just 0.4% with positive returns 56% of the time. In terms of the average return and consistency of positive returns, those values are below the average for all periods. In fact, the 0.4% average gain ranks as the second-worst of any yield handle. The only time returns were worse was when the 10-year had a yield of 14% or more!”
The broad thinking here is that there can be too much of a good thing (growth), to the point where the coupon on bonds becomes attractive relative to equities. Or that too much of a good thing also includes too much of a bad thing (inflation).
There are many market participants expecting (hoping?) that a Federal Reserve hike re-establishes the central bank’s “credibility” and will help stabilize the long end. That would be the mirror image of what took place during the easing cycle that started in 2024.
But long-term bond yields rose during that cutting campaign because it was viewed as successful in stabilizing and reinvigorating the business cycle. By that token, a tightening cycle can lower long-term yields if it’s perceived to be exerting sufficient downward pressure on growth and inflation.
An analysis from 3F Research founder Warren Pies suggests that unless today’s hike is a one-off, the upward trend in the 10-year yield has further to run:
Of course, continued hikes and rising long-term yields would hinge on the growth and inflation outlooks. And those could slow somewhat organically and independently of hikes (or, of course, not).
The stock market already appears to be pricing in a decelerating US consumer and the AI boom hitting some speed limits, though with significantly more uncertainty surrounding the latter than the former.
I don’t know what Kevin Warsh will say today, but I’m extremely confident that he will not suggest that the central bank is aiming to tighten policy to short-circuit any inflationary impulse from the AI spending boom. The Chair’s speech in Jackson Hole hailed AI as a potential catalyst for “substantially higher growth” and “new factor of production.”
(For what it’s worth, put me in the camp that believes other interest rate sectors will remain on the mat and consumers under angst before AI capex really rolls over.)
Looking at the internals of the equity market and the potential impact if the Fed does indeed proceed with tightening…
The usual suspects — non-profitable tech stocks and retail favorites — have been struggling as short-term interest rates rise.
These groups (particularly the former) contain stocks that are more speculative and reliant on short-term borrowing. So, it can hurt both psychologically (Fed tightening hitting risk appetite) as well as fundamentally.
I’d also lump small caps in with those two groups for similar reasons, even though their historical reaction to pain at the front end of the Treasury curve is much less negative. But lately, that’s held true: iShares Russell 2000 ETF has meaningfully underperformed the SPDR S&P 500 ETFsince the odds of a September hike began to ratchet higher in mid-August.
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Beyond that, it’s very difficult to make grand pronouncements about winners and losers from shifts in short and longer term interest rates because of a binary dynamic: Relative performance is seemingly always and everywhere a referendum on AI stocks, which make up a hefty portion of US market cap.
AI is the sun, and everything else orbits around it. How much so?
Well, typically, we’d expect high dividend stocks in the S&P 500 to underperform the index when rates are rising. But the excess return of the S&P 500 dividend index at its most negative correlation ever with long-term bonds over the past six months — that is, tending to best the benchmark US equity index when yields rise and lag when they fall.
The previous trough in correlations here, you’ll note, came in 1999.
Diesel-ling
Along with long-term rate relief, a reprieve from record high diesel cracks is also something that Corporate America would welcome.
Here are the S&P 500 companies whose share prices have been the most negatively correlated with the daily swings in ultra-low sulfur diesel over the past six months:
And these are just correlations, which have their limitations (see above: Franklin Resources) and infamously do not imply causation.
On the other hand, we have a very recent, explicit example of a company indicating that higher fuel costs are poised to weigh on performance this quarter: JB Hunt, which is tumbling in premarket trading after management issued an earnings warning at a conference on Tuesday evening.
And also, this:
Potpourri
BTIG’s Jonathan Krinsky hitting a theme we’ve discussed often here: there’s no good momentum!
“One of the arguments we keep hearing from clients and across various media outlets is ‘aren't you surprised how well the market holds up despite rates and crude?’. If you are just looking at the S&P 500, then sure. It's down less than 3% from its mid-August highs, while crude is up ~30%, and 10yr yields are up ~40bps over that span. It's easy to say: ‘man this market is so resilient’. But if you look below the surface, Industrials are -9%, equal-weight discretionary -8%, and small-caps are -6% over that span. More importantly, there is just no follow-through to upside breakouts. In other words, there's no mo'! This is what distribution looks like. Upside breakouts fail, and more and more stocks breakdown below support. Remember, market bottoms see most stocks capitulate at the same time. It tends to be an 'event'. Market tops are different, they see stocks roll over at different times until there is nothing left to support the key indices. We continue to think this churn resolves with a downside break on SPX and correlation-one selloff.”
Bank of America equity derivatives strategists led by Benjamin Bowler on how to play today:
“In our view, if the frontier labs truly believe AI is powerful enough to pose an existential threat, then AI must also be powerful enough to solve some of humanity's largest problems (e.g., Navier Stokes). In other words, AI's potential is rising as fast as its risks, motivating the need for risk-managed upside exposure to US equities. Hence, we like QQQ calls as a risk-limited way to buy dips, leveraging the recent abatement in call vols. For the upcoming FOMC, we favour hedging directly through macro assets, owning TLT gamma (call + put spreads).”
Deutsche Bank analyst Adrian Cox on the AI p(doom). He goes on to remind us of the many luminaries who’ve made awful predictions, citing Einstein’s doubts on nuclear energy, YouTube co-founder Steve Chen’s worries about a dearth of demand for videos, Microsoft’s Steve Ballmer hand-waving iPhone penetration, and fittingly for the present day, how bad markets have been at predicting the medium term trajectory of the Federal Reserve’s policy rate:
“For AI, it’s not just about what it will be able to do but also when it will be able to do it – whether more than $5 trillion in investment by the hyperscalers alone over the next five years will pay off before the advanced semiconductor chips they’re buying become redundant. It’s also about how rapidly and intensively AI can be adopted. Asset prices are a still more uncertain derivative, whipping around like the tail of a snake in response to every shift in expectations. US President Donald Trump and China found themselves on the same side in rebutting the latest concerns as fearmongering, albeit with Trump adding that America needs to stay ahead of China in AI. A glance through history would give any investor indigestion. Most predictions are wrong. The favourites in horse races lose 70 percent of races. It took a decade or more for demand to catch up with the infrastructure laid down in the British canal and railway and US telecoms and fibre booms – and many investors never recovered their capital. Technology predictions have a particularly mixed record as the binary order of the labs collides with the messy reality of the world. Famous examples range from IBM Chairman Thomas Watson’s underestimation of demand for computers in 1943 (‘I think there is a world market for maybe five computers’) to Elon Musk’s repeated overestimation of imminent widespread adoption of self-driving cars since 2013 (‘We should be able to do 90 percent of miles driven within three years’).
Technologists are not immune from making category errors, mistaking the most visible, automatable component of a job for the job itself. For example, radiologists, a favourite case study for believers in a jobs apocalypse, do much more than looking at images and making binary diagnoses. Much of their value lies in interpretation, judgement, communication and clinical decision-making. Ultimately, what we see in the future is not so much a window as a mirror into our own hopes and fears. And the problem is that hindsight makes what actually happens seem so obvious that we never seem to learn.”
Seen on Socials
Via Carl Quintanilla on BlueSky:
What to watch
Wednesday
Federal Reserve interest rate decision and updated economic projections due out at 2:00 p.m. ET.
Lennar slated to release quarterly results after the close.
