Stock Market Weakness More Than Seasonal?

The stock market has had a hard time rallying on favorable economic data during this seasonally weak period.  Profit-taking after the steep rally in July is reasonable.  The question, however, is whether  something more fundamental is pulling down stocks.  The run-up in longer-term Treasury yields is a potential culprit.   And, it could be tied to the rising Federal deficit and hints that Fed tightening will end soon.  Higher yields serve to crowd out private spending to make room for the fiscal stimulus.  And, the burden to do so falls more on longer-term yields if it looks like short-term rates will not rise much further.  One way private spending is held down is through wealth destruction in the stock market, as the higher long-term yields cut the present value of future earnings.

Many years ago, another economist and I published a New York Fed Research Paper showing that the Treasury yield curve would steepen if the expected Federal Deficit widened.  We augmented the Fed model's term structure equation with the projected Deficit and showed the latter to be statistically significant.  With this in mind, the increased subsidies stemming from the so-called Inflation Reduction Act, which apparently are larger than had been expected, could be a factor behind the run-up in longer-term yields.  On top of this, the sharp increase in Treasury issuance following the debt ceiling fight in June could be exerting a significant temporary boost in yields, as well.  

Some of the run-up in longer-term yields could unwind ahead if congestion from heavy Treasury issuance abates in the next few months.  However, the need to crowd out private spending to make room for subsidized spending suggests longer-term yields will not fall by much, unless the Fed tightens more aggressively.  In the latter case, the short-end of the curve will take on more of the burden to restrain demand.

The more volatile Foreign Exchange market could be a factor lifting longer-term yields, as well.  Our Research Paper showed that the volatility of the dollar in the FX market also impacts the term structure of Treasury yields.  

The actual inflation data are not the issue regarding high long-term yields.  The underlying CPI (Core less Shelter and Used Car Prices) was flat in July for the second month in a row.  And, while the PPI was slightly above consensus, the culprits appear to be narrowly situated in the financial sector.  The longer-run 5-Year Inflation Expectations in the University of Michigan Consumer Sentiment Index slipped back to 2.9% in mid-August.  The Treasury market could be extra sensitive to the recent run-up in commodity prices, however.

At this point, an ending of the downward pressure on the stock market may require an abatement in Treasury issuance and a flattening out in commodity prices.  A sharp decline in commodity prices would not likely help stocks, as it would suggest economic weakness.  This week's US economic data are expected to show this is not the case.  Consensus looks for increases in July Retail Sales, Housing Starts and Industrial Production.  The Atlanta Fed model's latest estimate of Q323 Real GDP Growth is a strong 4.1% (q/q, saar).