We've talked about the bond market as a shock risk that could quickly get to a flashpoint.
With that, the strong jobs number this past Friday has extended the surge in the U.S. 10-year yield to as high as 4.80%. That's the highest level since November of 2023 (more than a year ago).
And as we've discussed, this rise in bond yields (which has diverged from the direction of Fed policy) has put pressure on stocks.
Let's take a look at a couple of charts …
Above is a look at the interest-rate-sensitive small caps index.
The trendline represents the bull cycle for small caps that started in October of 2023, when Jerome Powell signaled the end of the tightening cycle.
If we look at the Russell compared to the less rate sensitive Nasdaq (below), we can see these divergences along the way.
In this first circle, the divergence closed with the Russell falling (the orange line), as the Fed started curbing what were very aggressive rate cut expectations priced into markets.
In the second circle, the divergence gap was closed with a sharp rise in the Russell. And it was triggered by inflation data that showed the first monthly price decline since May of 2020.
And now, in this third circle, we have another divergence between the Russell and Nasdaq, with small caps now in a 12% correction. And this comes as we enter another big inflation data point to be reported on Wednesday (the December CPI report).
With that, we go into this inflation report with the market already leaning in the direction of a more hawkish rate path for the year than the Fed has projected (which has weighed on small caps).
The market is now pricing in just one quarter point rate cut for 2025, while the most recent Fed Summary of Economic Projections (from the December meeting) is looking for two quarter point cuts this year.
So, what are CPI expectations? Pretty hot.
Reuters has the monthly headline inflation change expected at 0.3%. The Wall Street Journal's consensus Wall Street view is higher at 0.38%.
A positive surprise (i.e. a touch softer inflation) would relieve some pressure in the bond market, and fuel a bounce in small caps.
A hot number would push yields toward 5% (and stocks a lower) …
If so, we should expect a 5% yield on the 10-year Treasury to be the "uncle point" for the Fed, again.
We should expect a similar response to what we saw in October of 2023: A Fed that will quickly swing the pendulum to unanimously dovish, and be vocal about it, in order to talk bond yields down.