Volatility Masks Market Stabilization, But Not Over Yet

Believe it or not, the stock and Treasury markets stabilized last week, helped by a softening in almost all the US economic data releases.  The S&P 500 Index was flat over the week.  The 10-year Treasury yield stayed below the 3.23% high of early October.  Sharp volatility masked the stabilization, some of it sparked by an incorrect reaction to the FOMC Minutes and by fear of a Chinese economic slowdown.  Portfolio Managers' window dressing and program trading may have exacerbated the volatility, as well.  Fears of the Fed and global growth, as well as portfolio adjustments, could continue to buffet the markets into November. 

A year-end stock market rally, nevertheless, can happen.  Two fundamental triggers to watch for are lower y/y Core PCE Deflator inflation that could persuade the Fed to skip a December hike and an easing in the China/US trade war at a meeting of their leaders in late November.

Although the stock and Treasury markets reacted negatively to the September FOMC Meeting Minutes, the latter, in fact, had little, if any, new news in them.  The Fed remains committed to a gradual approach to tightening, and whether they diverge from that path is data dependent.  The only update is the Fed staff's slight adjustments in their projections of near-term Real GDP Growth in response to the September hurricanes -- slight downward to Q318 and slight upward revision to Q418.  Weak data in September need to rebound in October-November to confirm their forecast.  This coming week's data are for September, and therefore not important if they are weak.

An economic slowdown outside of the US could hold the clue as to whether the Fed will stop tightening earlier than planned.  There are two elements.  First, a slowdown in foreign economic growth hurts US exports.  Even though the US does not export a lot to China, a slowdown in the latter impacts EM countries that supply materials to it.  Their demand for US goods, in turn, would decline.  To be sure, a US economic slowdown to under 3% is what the Fed wants.  So, unless growth looks like it will slow much more, say to under 2%, a slowdown in Real GDP Growth may not stop the Fed from tightening further.

Second, slower foreign growth holds down US inflation -- and this could be the more important influence on Fed policy.   Relatively weak growth abroad helps lift the dollar.  It also depresses prices and wages abroad.  And, it puts downward pressure on commodity prices.  US import prices should fall, not only holding down US inflation directly but also indirectly through competitive pressures on domestic prices and wages.  These forces would come on top of a possible slowdown in owners' equivalent rent, as suggested in the September CPI.

A decline in the y/y for the Core PCE Deflator to below the Fed's 2.0% target could persuade officials to stop tightening.  The Core PCE Deflator needs to average less than 0.177% m/m from September through December to pull down the y/y to under 2.0%.  There is a good chance the next report, for September (due October 29), will meet this requirement.   The October and November CPI will be released before the December 18-19 FOMC Meeting.

Further ahead, a meeting between Trump and Chinese President Xi Jinping on November 29 at a G-20 summit in Buenos Aires is reported to be shaping up, according to Politico.  This could put a lid on fears of a worsening trade war, helping the stock market to recover even before the meeting.