Shares rally amid signs of lower US inflation

A year-end rally is gathering pace as cooling US economic activity and progress in lowering inflation signals the end of the most aggressive US rate hikes since the 1970s.

A year-end rally in shares is gathering pace as cooling US economic activity and faster than expected progress in lowering inflation signals the end of the most aggressive US rate hikes since the 1970s.

Thursday’s 1.4 per cent lift in Australia’s S&P/ASX 200 to a two-month high close of 7105.9 points was the biggest one-day rise in four months and the fourth biggest rise this year.

The S&P/ASX 200 has risen more than 5 per cent from a 12-month low of 6751.3 two weeks ago.

It came as the S&P 500 leapt 1.9 per cent after lower than expected CPI data, to be up 9.5 per cent from its recent low. That followed a 20 basis point drop in the US 10-year bond yield to a two-month low of 4.44 per cent, as US rate hike fears were replaced by growing expectations of rate cuts next year.

The market may now be ­getting overexcited about potential US interest rate cuts, but only the brave or foolhardy would defy such bullish momentum at the strongest time of year.

It was only last month that the US 10-year bond yield struck a 16-year high of 5.02 per cent after surging over 100bps in two months amid fear of more US rate hikes – fuelled by a more aggressive “dot plot” from Federal Reserve officials at the September FOMC meeting.

The ensuing sell-off in US and Australian shares saw both markets briefly enter “correction” territory, defined as a fall of at least 10 per cent from their bull market peaks.

Fast-forward to this week, and the 10-year bond yield has dropped an equally astonishing 58bps in three weeks, significantly lessening the valuation hurdle for shares, while also giving hope for corporate America as the fall in yields has been led by the short end amid hopes of rate cuts.

It started with a concerted acknowledgment by Fed officials that surging bond yields had tightened financial conditions to the extent that they lessened the need for more rate hikes – a message that was viewed by seasoned professionals as a “pivot” away from rate hikes by the Fed.

That was later backed up by a weak US non-farm payrolls report which included slightly lower than expected average hourly earnings. Then the October CPI report showed core inflation undershot expectations. No doubt if US PPI and retail sales data follow the pattern, the simultaneous rally in bonds and equities will continue into the weekend.

As the Wall Street Journal’s Fed whisperer Nick Timiraos tweeted after the CPI data, the potent combination of softer October payrolls and CPI reports “strongly suggest the Fed’s last rate rise was in July”. The “debate at the next Fed meeting is shaping up to be over whether and how to modify the post-meeting statement to reflect the obvious: the central bank is on hold.”

Still, at some point – perhaps in the cold hard light of the New Year – markets will find they’re getting ahead of themselves in pricing multiple US rate cuts next year, according to GSFM investment strategist and former BlackRock head of fixed income, Stephen Miller.

A slightly better than expected core CPI for October does suggest that the Fed tightening cycle is “likely in abeyance, probably indefinitely”, as inflation now appears to be tracking a little lower than the Fed’s September projections,” he says.

But the Fed could well retain its “high for longer” mantra, meaning that any policy rate cuts won’t come until well into 2024, and not be as big as the 100bps of cuts now priced in.

Why would the Fed cut four times unless a recession was obviously on the cards or inflation was obviously going to undershoot its 2 per cent target?

“It’s not obvious to me that the Fed would contemplate any reduction in the policy rate in accordance with some of the more aggressive projections in the market,” Mr Miller says.

“It appears to me that the extent of easing currently priced into markets – while not implausible – implies a policy rate through 2024 that is located at the low end of the risk continuum.”

The bond market has, after all, consistently underestimated how high the Fed would take the policy rate and how far it has been from contemplating rate cuts in this cycle.

Markets have more recently tempered their difference of view with the Fed.

But with exuberance showing signs of reasserting itself, the Fed won’t want to see that undermine the hard-won gains to date in containing inflation via a premature easing of financial conditions.