Implications of Last Week's Sell-Offs in Treasuries and Stocks

The unexpected run-up in longer-term Treasury yields and the consequential drop in stocks late last week may have been an overreaction to Fed Chair Powell's comment, but they have put both markets on the defensive immediately ahead.  The September CPI (due Thursday) and the Q318 earnings season (begins this week) will be important.  The CPI report may very well be in line with consensus, but a possible uptick in the y/y could spark selling in the markets.   Corporate earnings risk exceeding consensus again, but forward guidance could be a problem.  In the background, uncertainty regarding the mid-term elections and their implications could weigh on stocks over the next few weeks.  A year-end rally in stocks is still likely.

Treasury Market Sell-Off
Last week's sell-off in the Treasury market is said to have been sparked by a comment made by Fed Chair Powell in an interview that the funds rate is "a long way from neutral at this point, probably."  I believe the market may have overreacted to it for two reasons.  First, the comment may have been a "rookie" mistake, since Powell should not have been so specific regarding a concept that he, himself, has admitted is not measurable.  Moreover, Fed officials should realize their idea of magnitude may differ from that of the markets and thus refrain from opining on it if they do not state an estimated level.  Chicago Fed President Evans puts the neutral funds rate at 3.0-3.2%, for example.  Second, the Fed already specified its expectation for the funds rate's path in its Economic Projections and Dot Chart.  This is not new news for the markets.

Ironically, the markets' sell-offs could reinforce the Fed's intention to follow a gradual tightening path.  Besides not wanting to precipitate even larger sell-offs, Fed officials are not likely to be frustrated that their approach is not having an effect.  In contrast, back in 1994, Greenspan became frustrated that his 25-BP measured pace of tightening was not lifting longer-term yields.  As a result, he shocked the markets with 50-75 BP hikes -- that had the desired market effects.

The markets' real problem would be any further fiscal stimulus coming out of Washington -- the most likely being a push for infrastructure spending.  The latter would likely "require" the markets to move to crowd out other spending, given the labor market is near or at full employment -- yields would rise and stocks fall.  This scenario is probably more an issue for next year.  But, there could be talk of doing such spending after the elections, possibly a bi-partisan effort in Congress.

September Core CPI
The 0.2% m/m consensus estimate of the September Core CPI looks reasonable.  Some of the components, like apparel, that fell in August could decline again, thanks to bi-monthly sampling.  The stronger dollar should continue to exert some downward pressure on prices, while it is probably too soon to see any boost from the second round of tariffs on Chinese goods.  (The reported problems being experienced by Chinese companies from the tariffs suggest the latter are not being fully passed through.)  Further pass-through of higher oil prices, such as in airfares, is possible, however.  The y/y of the Core CPI should be 2.2-2.3%, versus 2.2% in August -- depending on rounding.  Consensus is 2.3%.  An uptick could be a problem for both Treasuries and stocks. 

Q318 Corporate Earnings
Corporate earnings should be strong in Q318, possibly exceeding the 21.5% y/y consensus estimate calculated by Thompson Reuters (versus 24.9% in Q318).  But, companies may lower future guidance to reflect the impact of tariffs and stronger dollar.  Domestic fundamentals remained strong in the quarter.  US Real GDP Growth on a y/y basis sped up, incorporating the 4.1% q/q Atlanta Fed model estimate for Q318.   Oil earnings should have accelerated.  And, domestic profit margins should have been stable, as prices (measured by the Core CPI) kept pace with Average Hourly Earnings.   However, earnings from abroad likely weakened, because of the stronger dollar and softer economic activity.  

                                                                                                                                          Markit
                                                                                                                                          Eurozone              Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q117            2.0                +65.3                  2.3                              2.7          2.2                55.6
Q217            2.2                +13.1                  3.1                              2.5          1.8                56.8
Q317            2.3                 +6.0                 -1.9                              2.5           1.7               57.4
Q417            2.5               +12.7                 -4.1                              2.5           1.7               59.7

Q118            2.8               +21.5                 -6.6                              2.7           1.9               59.1
Q218            2.9               +41.0                 -1.8                              2.7           2.2               55.9
Q318            3.2               +45.4                 +5.1                             2.8           2.3               54.3