Will the stock market rally turn into a selloff? This indicator of the bond market could deter investors

Now that the Federal Reserve appears to have abandoned its forward-guidance tool in favor of being “data-dependent” to help inform its future path for interest rates, investors should keep an eye on this gauge of inflation expectations for signs of a change in market sentiment. .

Watch the five-year breakeven rate, one of the most reliable indicators of inflation expectations, to help gauge the direction of the Fed’s monetary policy, a group of macro strategists from Jefferies Group JEF,
+0.21%
he said.

The five-year breakeven rate has helped predict the direction of stocks throughout the year and could well provide clues as to where stocks might be headed next, the group said.

The five-year breakeven rate represents the difference in yields between the nominal five-year Treasury bond TMUBMUSD05Y,
2.618%,
and the Treasury’s five-year inflation-protected note 9128286N55,
-0.174%.
Bond yields rise as prices fall.

According to the Federal Reserve Bank of St. Louis, this spread represents the premium demanded by holders of inflation-protected securities, making it an effective proxy for the market’s expectations of 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 U.S. stocks fell, the five-year breakeven rate fell sharply in late June and early July, finally hitting a 2022 low on July 6. when it broke below 2.5%, according to data from the St. Fed.

Source: St. Louis Fed

This recent decline, which has coincided with falling commodity prices and bond yields, appears to have preceded the latest slide in stocks. In July, the S&P 500 SPX,
-0.28%,
Dow Jones Industrial Average DJIA,
-0.14%
and Nasdaq Composite COMP,
-0.18%
Each posted its best month in about two years, with the Nasdaq rising more than 12%.

David Zervos, chief market strategist at Jefferies, said he expects the stock rally to continue in the coming days and weeks, but that he will be closely watching the five-year breakeven rate and economic data, in a note to clients on Sunday. .

“…[W]I expect [Fed Chairman] Jay [Powell] will be watching very closely how inflation expectations respond to this substantial change in the overall policy/guidance stance. So if inflation falls to the curb or survey data on inflation expectations starts to pick up, we’ll quickly see a change in Jay’s tone,” Zervos noted.

Measuring an axis of the Fed

The recent retreat in inflation expectations has prompted Fed funds futures traders to expect the policy rate to peak at 3.50% later this year, followed by rate cuts as early as next spring, according to the FedWatch tool of CME.

In response, economists at Deutsche Bank and Goldman Sachs analysts questioned whether investors have become too optimistic about potential rate cuts next year. So far, however, U.S. stocks appear to have sidestepped those concerns.

Looking ahead, investors will likely need to see a major shift in inflation expectations, or a serious deterioration in the strength of the labor market and underlying economy, to trigger another round of sharp selling in stocks, the Jefferies team wrote.

Because of that, the five-year breakeven rate will be “the key metric to watch to confirm the pivot” for both the Fed and stocks, Zervos said.

The Fed still wants 2% inflation.

Fed Chairman Powell has repeatedly emphasized the importance of inflation expectations in post-meeting press briefings. On Wednesday, he reiterated that the Fed aims “to return inflation to our 2% target and keep long-term inflation expectations well anchored.”

US inflation remained at a 40-year high through the end of June, according to the latest reading of the personal consumption price index, released days after the Fed raised interest rates last week. A day later, second-quarter gross domestic product data confirmed that the US economy shrank again in the second quarter, sparking more debate about whether the US economy has already entered a recession.

Reading: Is the US in a recession now? Not yet — and here’s why

Market-based indicators have been particularly useful at a time when the Fed has all but abandoned forward guidance, leaving investors to sift through conflicting messages from Powell and other Fed officials.

Many equity strategists cheered the prospect of a Fed pivot, or a move away from aggressive rate hikes, later this year. But Minneapolis Fed President Neil Cascari told The New York Times and CBS News in recent days that the Fed remains “a long way” from backing down in the inflation battle.

On Monday, Bloomberg News published an editorial by former New York Fed President Bill Dudley, who criticized investors’ “wishful thinking” about the Fed’s pivot as “unfounded and counterproductive.”

From a purely technical perspective, some market technicians expect stocks to be poised for more upside after recovering nearly half of their year-to-date losses.

For the S&P 500, the next key resistance level will be 4,178, according to John Kosar, chief market strategist at Asbury Research. If the US benchmark trades above this level for at least several sessions, the next key resistance level will be between 4,279 and 4,346. The next key “support” level for the S&P 500, should it break down, would be between 3,922 and 3,946.

Reading: US stocks struggle for direction after best month for S&P 500, Dow since November 2020

US stocks lost their grip on modest gains on Monday afternoon. The benchmark was down 0.4 percent at about 4,105, while the Nasdaq Composite was down 0.5 percent near 12,316 in afternoon trade. The Dow Jones industrial average was down 0.4% near 32,698.

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