The markets were in motion coming off the U.S. Memorial Day weekend, driven mostly by the chaos in Italian politics which has put anti-EU and anti-Euro sentiment in the spotlight.
The Euro weakened against almost every currency, while the yen strengthened against the U.S. dollar.
U.S. large cap equities sold off aggressively. At one point the Dow Jones Industrial Average was down 505 points, then rallied back a little to finish down 391 points.
The main market event, though, was the huge shift to risk-off, sending the U.S. Treasury 10-year Note yield down to 2.78 percent, compared to 3.11 percent only 12 days ago. This is a huge, if not unprecedented, move similar to the one-day move after the Brexit referendum back in June 2016. All of this action sent CME Group trading volume to an all-time daily record above 50 million contracts.
The behavior in the bond market had the earmarks of panic closing of positions. Many buy-side firms had embraced the view that tax cuts mean more growth, inflation is rising, rates are rising and a bear market in bonds is now here. It was this sentiment that took the 10-year from around 2.4 percent at the end of 2017 to 3.11 percent on May 17. Risk-off reversed this sentiment in a New York minute. In fact, CME Group interest rate futures reached a record 39.6 million in trading volume.
Going forward, what does this market action mean for the Fed, equities, and bonds?
First, the employment report on June 1 should provide plenty of support for a Fed rate rise in mid-June. What happens in the second half of the year is in doubt, also a view we have taken in our research.
Inflation is only inching higher in fits and starts. The yield curve has flattened in a way that will give pause to some FOMC members, simply because a flatter yield curve is a statistically significant predictor of future equity volatility and sometimes a recession – also covered extensively in research by Erik Norland. The Fed will remain data dependent, looking at both core inflation and the yield curve. My current best estimate is only one rate rise in the second half of 2018, coming in December.
Second, the equity reaction seems overdone. Corporate profits are very strong, even if future earnings growth rates will be much slower. Unemployment remains extremely low and buying power of consumers is strong.
Third, Italy has a long history of unstable governments. Today was an overreaction if history is a guide. So, we may see a partial move in the 10-year Note back toward 3 percent, which will provide strong resistance until we see unambiguous higher core inflation data.