Fed Cuts Loom: S&P 500 Defies Economic Trends

By Athena Xu

7/11, 09:35 EDT

Economic Surprises and Equity Markets: A Divergence Worth Watching

Inflation Eases, Fed Cuts on the Horizon

Recent economic data has set the stage for potential Federal Reserve rate cuts by the end of the year. Thursday's Consumer Price Index (CPI) report revealed lower-than-expected inflation, both in headline and core readings. This has opened the door for an easing cycle to potentially begin as early as September.

  • CPI Data: Both headline and core CPI undershot expectations, with key inflation drivers like shelter and core services showing significant moderation.
  • Market Reaction: The Treasury market rallied as anticipated, but the most notable move was in USD/JPY, reflecting that a benign inflation outcome had not been fully priced in.
  • Fed Cuts: Financial markets have now fully discounted two Fed rate cuts by the end of the year, aligning with the easing inflationary pressures.

Equity Market Anomalies and Economic Surprise

Despite the positive inflation news, there is a growing divergence between stock prices and economic surprise trends. This divergence raises questions about the sustainability of the current equity market rally.

  • Equity Price Action: US equity prices have shown anomalous behavior, with the S&P 500 posting an 18.3% rally over the last six months, despite economic surprises suggesting a more modest performance.
  • Economic Surprise Index: Historical data shows a positive contemporaneous relationship between the Bloomberg Economic Surprise Index and the S&P 500, with a six-month window being the most indicative (correlation coefficient of 0.5).
  • Model vs. Reality: Based on economic surprise alone, the S&P 500 should have dropped about 5% over the past six months, highlighting the current market's overperformance.

A Thought

The current divergence between stock prices and economic surprise metrics suggests that the equity market may be pricing in more optimism than warranted by economic fundamentals. As we approach the forthcoming earnings season, the sustainability of rising earnings expectations will be crucial. Additionally, the low realized volatility in the face of economic surprises seems increasingly anomalous, warranting close attention from investors.