Stocks Continue To Misprice The Fed's Path To Even Higher Rates

The latest data suggests that the job market remains tight and that the path of least resistance for interest rates is higher. Meanwhile, stocks continue to misprice interest rate risk, even as interest rates push past key resistance levels. Stocks continue getting more expensive relative to rates, meaning remaining in high-quality names and carrying extra cash is prudent.

Additionally, the latest Fed minutes indicated that many Fed officials would have liked to have continued to raise interest rates in June, but that the calls for a "skip" prevailed.

The dovish case to not raise the overnight rate seemed to hinge on some job indicators suggesting a softening in the labor market. The minutes specifically pointed to weaker trends witnessed in the ADP survey.

The minutes noted that:

Some participants pointed out that payroll gains had remained robust but noted that some other measures of employment—such as those based on the Bureau of Labor Statistics’ household survey, the Quarterly Census of Employment and Wages, or the Board staff’s measure of private employment using data from the payroll processing firm ADP—suggested that job growth may have been weaker than indicated by payroll employment.

Strong Jobs Data Points To Higher Rates

Of course, that whole theory went out the window on Thursday when the ADP data showed robust job gains in June, rising by 497,000 vs. estimates of 225,000. That was the largest one-month gain in employment as measured by ADP in nearly a year.

Another case to pause in June showed that the average hours worked had declined in recent months. That number also improved in June, rising to 34.4 hours from 34.3 hours in May. Yes, that number is weaker than at the peak in early 2021, but it does seem consistent with values witnessed from 2010 until 2019 before the pandemic.

Meanwhile, as of May, 1.67 times more job openings remain than the number of unemployed workers. This number remains exceptionally high and well above the 2018 and 2019 highs. This suggests that worker demand remains very high, and the 3.6% unemployment rate coupled with wage growth indicates the tight labor market.

Wage growth on a year-over-year basis has flatlined over the last few months at around 4.4% after peaking at 5.9% in March 2022. The current value of 4.4% also is well above the average of 2.9% from July 2016 until February 2020. Additionally, a 4.4% year-over-year wage increase certainly is not consistent with a 2% inflation rate; assuming a 1% productivity rate, wage growth equates to a roughly 3.5% inflation rate.

Higher Rates

Unsurprisingly, the market is now pricing in about a 90% chance for a rate hike in July. Especially now, since the principal calls for some members of the Fed calling for a skip at the June meeting didn't seem to play out as expected.

It's also no surprise that the stronger-than-expected employment data has pushed rates on the back of the nominal yield curve sharply higher this week, while real rates rose sharply too. We saw the 10-year and 30-year nominal rate rise above 4% this past week, gaining more than 15 bps.

Additionally, real yields rose sharply to new cycle highs on the 5-year and 10-year TIP rates. The 5-Year TIP is now trading at 2.1%, while the 10-year TIP rate is now at 1.76%.

That has helped to push the equity risk premium between the Nasdaq earnings yield and the 10-yr TIP rate to just 1.24%, a new cycle low. It used to be that the spread between the Nasdaq earnings yield and the 10-yr TIP rate averaged a spread of about 3.8% from 2013 until early 2022. That spread has narrowed considerably, suggesting that the growth-oriented Nasdaq 100 is now extremely overvalued vs. its average of the past 10 years.

But more importantly, it seems that this spread is poised to narrow further unless the equity market begins to pay attention to the warnings of the bond market for higher rates. The 10-year Treasury rate this week rose above a key downtrend that formed in October 2022 while also moving above a resistance level in the channel portion of a cup and handle pattern. This would indicate that the 10-year is likely to rise above 4.1% and even challenge, if not exceed, the highs in October around 4.3%.

The same is true of the current 30-year rate, which also is breaking free of its consolidation phase since December. This would suggest the 30-year rate could rise to around 4.3% or even beyond 4.4% in the not too distant future.

Higher rates on the long end of the curve also mean higher real yields for the inflation-protected TIPs, and the higher real yields get, the more expensive stocks become relative to those real yields.

The relationship between real rates and stocks was the centerpiece of the past 10 years, and now suddenly, stocks seem to have completely disconnected from that relationship. It's either because something has changed, which has not become material clear yet, or there's a lot of pain coming the equity market's way soon, and there will be a big push below 4,200 on the S&P 500 and potentially lower coming.

It means staying in high-quality defensive names and carrying extra cash remains the prudent decision at this point.

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