November 10 mega market rally: A look at the bigger picture

Yesterday’s softer-than-expected U.S. Consumer Price Index (CPI) data was extremely well received by the market—reflecting just how important the inflation picture is to the outlook, and how desperate the market has been for positive news on this front.

Markets surged, with the S&P 500 rising 5.54%—its best daily performance since April 2020. To put this into context, since 1962, the S&P 500 has only recorded a greater daily increase on 14 occasions. The NASDAQ rose 7.35% and the FANG+ index rose 9.39%.

Bond markets reacted equally violently. Two-year U.S. Treasury yields dropped 24 basis points—the largest daily decline since 2008, while the 10-year yield dropped 27 bps to fall back below 4%.

CPI report details

Consumer Price Index (CPI) inflation
Year-over-year, 2020–present

Annual headline CPI fell to 7.7% in October versus expectations for a decline to 7.9%. More importantly, annual core CPI fell from 6.5% to 6.3%, and monthly core CPI only rose by 0.3% (expected 0.5%)—the smallest increase since September 2021. The improvement was broad-based, with core goods inflation recording its first monthly drop since March 2022 and core services inflation easing from 0.8% in September to 0.5% in October.

The Fed picture

Fed funds futures movement
Implied fed funds target rate, November 9 vs. November 11

The CPI report delivered a boost to hopes that the Federal Reserve (Fed) can slow their pace of tightening and even pause rate hikes sooner, reviving the Fed pivot narrative. Indeed, markets have lowered their expectations for the terminal Fed funds rate to below 5% and are now pricing in two Fed cuts before the end of 2023. The “higher for longer” theme is being questioned.

Certainly, the inflation data has all but cemented a downshift in the pace of tightening. After delivering four consecutive 75 bps hikes, we expect (and have been expecting for some time) the Fed to raise rates at their next meeting in December by “just” 50 bps. We believe, however, that talks of a Fed pause are still too premature and that, beyond December, there will likely still be a few more rate hikes. Consider that:

• While inflation has likely peaked, it still remains very elevated. Headline inflation is almost four times higher than the Fed’s 2% target.
• Fed Chair Jerome Powell has noted several times that they need to see a series of weaker inflation prints before they can feel any confidence about the inflation outlook. Recall that core CPI eased to 0.3% month-on-month in July to much market fanfare, only to rise 0.6% in each of the two following months. The Fed does not want to be wrong-footed by one piece of data.
• The key concern about elevated inflation is that it results in persistent and uncomfortably high wage growth. Yesterday the Atlanta Fed wage growth tracker was released and showed that the three-month moving average of annual wage growth remained unchanged at 6.7% in October. Admittedly, that’s below the 7.1% peak, but it is also higher than every other print on record. Clearly there is still work to do.
• Fed speakers continued to strike a cautious tone even after the CPI print. Dallas Fed President Lorie Logan noted that the inflation number was “a welcome relief, but there is still a long way to go.” She endorsed market expectations for a slowdown in the pace of rate hiking, but also commented that “a slower pace should not be taken to represent easier policy.”

Taking a step back

The October CPI print has not fundamentally changed the inflation picture much. Inflation has peaked and is coming down, but there is still some way to go before the Fed can pause, let alone before Fed policy can turn stimulative again.

Yesterday’s significant rally suggests the market is getting a little carried away—a rise in policy rates to 5% is still very much on the cards. Indeed, it would just take a 50 bps hike in December and one more 50 bps hike in February (or two 25 bps hikes in 2023) for policy rates to hit 5%. Furthermore, having permitted inflation to run wild in 2022, the Fed will not let itself make that mistake again and will likely keep rates at restrictive levels for a prolonged period.

Market implications

Inevitably, after such a violent and euphoric market move, investors will be questioning whether the rally can be sustained. Several factors suggest this rally could have some (short) legs.

1. Technicals: Sentiment surveys and positioning had been very negative coming into Q4, suggesting the market was ripe for a technical rebound.
2. Mid-term elections: Markets have rallied after the last 19 mid-term elections. Note, however, that this is likely to due to the clearing up of political uncertainty rather than anything else, and can only carry the market so far.
3. China reopening: China has announced a loosening of certain COVID restrictions, reigniting hopes of a reopening with potentially significant implications for China’s economic recovery.

Unfortunately, however, the medium-term outlook for market weakness has not changed. Continued inflation caution and the prospect of further Fed hikes is laying the groundwork for U.S. recession in Q2 2023. Note that even amidst the optimism following the CPI report, the Fed’s preferred yield curve measure (forward rate spreads between 3-month borrowing rates and implied 3-months rates for 18 months’ time) for predicting recession plunged sharply into inversion territory yesterday.

Once technical factors and mid-term election relief are exhausted, risk assets will likely once again confront this challenging economic backdrop. Inevitably, after such significant market falls this year, there will be pockets of opportunities in the market—but these will need to be actively sought out by investors.