The stock market may continue to be buoyed by the possibility of Fed downshifting after the November 1-2 FOMC Meeting -- a possibility highlighted by Friday's WSJ article. But, a stock market bounce could be short-lived if longer-term Treasury yields jump as a result.
Such reaction by yields is conceivable. The Treasury market could be concerned that monetary policy downshifting is premature. If the market is not persuaded that economic growth and inflation will slow, the yield curve could steepen. This would be a problem for stocks. With the Fed relying on tighter financial market conditions to bring inflation under control, bond yields have tended to jump when stocks bounce in response to a positive fundamental factor, like profits, or to holding technical support. The higher yields have undermined the stock market's move, forcing it back to supporting the Fed's goal. This "vigilante" role of the bond market could prevent stocks from reacting positively to a hint of future downshifting by the Fed at the November 1-2 FOMC Meeting.
To be sure, there are secondary effects of a policy downshifting that could help hold down longer-term Treasury yields. A consequential reduction in the volatility of short-term rates as well as of dollar exchange rates should flatten the curve, according to some models.
Evidence that the Fed is achieving its goals (lower wage/price inflation and softer labor market) may be what's needed to prevent a run-up in longer-term yields. With the Fed succeeding, financial markets would not have to "work" as hard to support the Fed. So the Treasury market could be comfortable with stocks breaking to the upside.
In this light, the Q322 Employment Cost Index (ECI) could be the most important US economic data to be released this week. It is a broad measure of labor cost inflation and little affected by compositional shifts. Consensus looks for the ECI to rise +1.3% q/q, the same as in Q222. This estimate may be somewhat high. /1/ While Average Hourly Earnings (AHE) sped up a bit in Q322, it remained below 1.3% (see table below). But, AHE is a narrower measure of labor costs than the ECI, not covering many types of workers nor types of compensation, such as bonus payments. As a result, the two can diverge considerably in a quarter, as was the case in Q421. /2/ Away from AHE, a reduction in sales commissions, such as for realtors, could hold down the Q322ECI.
A below-consensus print for the ECI probably would be positive for the markets, but a print of 1.0% or higher still could be problematic for the Fed. It would be well above the 0.6--0.7% trend prior to the pandemic. A sub-1.0% print may be needed to satisfy the Fed and to truly lift stocks.
(q/q percent change)
Avg Hourly Earnings ECI
Q321 1.3 1.2
Q4 1.5 1.0
Q1 1.2 1.4
Q2 1.1 1.3
Q3 1.2 na
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