The Markets’ Moment Of Truth Comes This Week

This week’s inflation data is expected to show that the Fed still has a long way to go and that the “markets'” (as in the collective) expectations for 5.5 rate cuts in 2024 are still too aggressive and more fantasy than reality. Core CPI is expected to rise in December at a rate inconsistent with a 2% inflation, while headline CPI is expected to accelerate from last month’s reading, too.

It won’t just be inflation that will be in focus this week, which could affect markets. Treasury issuance will be front and center at the 1 PM ET slot, as we see the return of the 3-Year Treasury auction on January 9, the 10-Year Treasury on January 10, and the 30-Year Treasury on January 11. Of course, the CPI report won’t come until the morning of January 11.

Fewer Cuts Starting To Be Priced

Some progress was made this past week, though, with the market effectively removing rate cuts from the equations, which had previously been looking for 6.5 rate cuts in 2024, following the hotter-than-expected headline non-farm payroll report and more robust wage growth, even though the report was riddled with more questions than answers, as previously noted. As also pointed out to members in a separate article, the jobs report reeked of stagflation, which could lead to margin compression as the year progresses.

The View

As noted, last week, I have continued to be bearish on the stock market because I believed that inflation would stay stickier and that the economy would remain stronger than expected, creating a higher for longer policy path, with the higher rate environment leading to multiple contraction and keeping a lid on stock prices. After correctly seeing the peak in the July rally, things seemed to go as expected through the end of October, as the index returned to 4,100.

Then, things suddenly and unexpectedly changed in November following the Treasury Refunding Announcement. To add insult to injury, the Fed threw gasoline onto the fire when it failed to push back against the recent easing of financial conditions. It sent markets even higher, making for a painful end-of-year rally to the analysis that took months to assemble. However, a chance for redemption has started, as noted on December 24, when the bubble appeared ready to burst, along with my belief that the index can still return to 4,100 over the next several weeks.

Inflation Forecasts

That road to redemption could continue this week, especially if the inflation data shows that the Fed won’t be able to cut rates as aggressively as the 5.5 times the market has priced in for 2024. Indeed, if inflation comes in as expected, the path to 5.5 rate cuts will need to be revised again, even more so if inflation should come hotter.

As of January 6, analysts forecast CPI to rise by 0.2% m/m, up from 0.1% in November, while increasing by 3.2% y/y, up from 3.1% y/y last month. Meanwhile, core inflation is expected to increase by 0.3% m/m and to be in line with November while decelerating to 3.8% y/y from 4.0% in November.

The issue is that the swaps market doesn’t see things the same. Inflation swaps for December are pricing CPI to rise 0.25% m/m while rising by 3.32% y/y. Meanwhile, the Cleveland Fed also forecasts the CPI to be 3.3% y/y. Kalshi is in line with the median consensus forecast and expects CPI to rise by 3.2%, while Bloomberg Economics forecasts CPI to fall below the median at 3.05%.

Treasury Auctions

Inflation will not be the only thing moving the rate market, with the Treasury auctions and, more importantly, their results being on the top of mind. Treasury auctions haven’t gone very smoothly in recent months. The 30-year auction in November stands out as having one of the widest tails since 2011. While the high yield tail in December was smaller than in November versus the average yield in the auction at -0.06%, it was still above the historical median of -0.055%. Since the start of 2022, the average tail has been around eight bps.

That has partially been because indirect bidders have been pulling back on their participation in recent auctions, with primary dealers being left to pick up the slack. The auction in December went well, with the indirect bidder making a return, taking some of the pressure off the primary dealers. Whether that trend will continue is yet to be seen. Since this auction takes place following the CPI report, the outcome of the inflation report could impact how the 30-year auction goes.

More recently, there have been technical signs that rates on the back of the curve could march higher. The 30-year Treasury just this week broke above a key downtrend for rates and the relative strength index. If the 30-year could clear 4.2%, it could result in the year heading higher back towards the 4.4% to 4.8% range.

We are now also seeing short positions being entered again for the Treasury bond futures and approaching the levels seen in September at their peak. It is also worth pointing out that the rising Treasury prices have led to long positions in futures reaching their highest levels in 5 years. But if rates are breaking out, and the data and auctions support rates moving higher, it seems more likely than not that those long positions will start to get closed out.

Back To Stocks

If the data supports rate cuts being priced out and rates on the back of the curve also going higher. Then it goes back to “The View” that stocks are currently overvalued and that as rates rise, it will work against stocks moving higher and push them down from current levels.

The S&P 500 has, as of Friday, flipped back into negative gamma, and the negative gamma regime works to increase implied volatility. Rising implied volatility will mean the market maker hedging flows will move with the market’s direction, and falling markets will be accompanied by downward dealer flows. According to Gamma Labs, the zero gamma level is around 4,720. The index needs to rise above 4,720 in order to get back into positive gamma regime, at that point the market maker flows would become supportive of a lower implied volatility environment and favorable to see stocks rise.

Finally, if the index falls below 4,640, a level provided by Nomura in a trading note, it would likely result in systematic funds becoming sellers, adding another layer of volatility and selling pressure to the market. The S&P 500 has already fallen below the 20-day moving average, and least historically, by the time the 20-day moving average falls below the 120 moving average, these systematic funds are either long or short the S&P 500 futures.

All of this continues to point to the fact that the market has made a major bet once again on Fed policy and is now looking for an aggressive number of rate cuts from the Fed in 2024. Every data point that doesn’t support the number of rate cuts priced in by the market is a hawkish event, even if the data comes in line. At this point, getting the Fed to cut rates by the expected amount will take weaker data. In line with hotter data, rate cuts are priced out, rates across the treasury curve rise, and the equity market valuation will readjust to a lower level to account for those rate-cut expectations.