As we discussed last week, the Fed specifically went after jobs as the mechanism to bring down demand, and therefore bring down inflation from multi-decade highs.

The question is, did it come at the expense of an economic recession?

There are signals flashing.

Take a look at the 2-year yield …

The 2-year is now down more than 80 basis points from late July.

That’s 175 basis points lower than the Fed Funds rate.  The bond market is telling us the Fed is way behind the curve — too slow to recognize the deterioration in the job market (and the economy).

So, the front end of the yield curve has collapsed, and the yield curve is now positive sloping, after two years of inversion.

Yield curve inversions are historically predictors of recession.

When the curve turns positive again, it tends to indicate an economy has either entered or is about to enter recession.

What else is flashing a warning signal?

Oil.

Oil is down 13% in seven days, trading near the lows of the past three years.  The last time we had a seven-day decline of that magnitude was March of 2023, surrounding the bank shock.

Of course, the bank shock was cleaned up with more central bank intervention.  Similarly, the recent carry trade shock was, at the very least, curbed through verbal intervention (by the Bank of Japan).

So, we have some signals flashing in a world where central banks have made a habit of cancelling market signals.

We get the August jobs report tomorrow.

What’s the one thing the Fed has threatened, dating back to March?

Jobs.

With that, over the course of this tightening cycle, negative surprises in the jobs report have been a positive catalyst for stocks.

Why? 

Because the weaker picture on jobs served as a signal that perhaps the exuberance was lifting in the economy, that the leverage for job seekers to negotiate higher wages might be abating, and therefore the backdrop for cooling inflation was forming (according to the Fed’s plan).  And the progression of that formula suggested the Fed’s inflation fighting campaign could come to an end, if not reverse.

So bad news was good news. 

Fast forward two-and-a-half years, and negative surprises in what has been deteriorating jobs data is no longer good news. 

Bad news is bad news.  

Why? 

With the inflation rate having normalized and economic growth arguably running below potential (given all of the fiscal spending), a rapidly rising unemployment rate may mean the Fed held its foot on the brake for too long — and that damage has been done to the economy. 

This all confirms the end of the inflation fight, and puts the Fed in an easing stance, but markets will want to see a Fed response that’s aggressive enough to stabilize jobs and economic conditions.

With the above in mind, stocks are already down 2.5% for the month of September, heading into tomorrow’s number.

This big trendline we’ve been watching in stocks dates back to October of last year, when Jerome Powell signaled the end of the tightening cycle. 

As you can see, this line broke on August 2nd on the weak jobs report last month.  And here we are again, after the V-shaped recovery of that sharp decline last month — stocks are back below this line heading into tomorrow’s number.

Add to all of this, the dynamics that exacerbated the selling in stocks in early August remain today (i.e. prospective monetary policy divergence between the Bank of Japan and the Fed — which reduces incentives in the carry trade).  

And there may be some seasonal influence on stocks here too.  Let’s take a look at the past four Septembers (2023, 2022, 2021, 2020).

September 2023 (S&P) was down 5%.  

September 2022 was down 9%.

September 2021 was down almost 5%. 

September 2020 was down almost 4%.

That’s the bad news.  Here’s the good news. 

Each of these bad Septembers was followed by a good fourth quarter. 

Fourth quarter 2023 (S&P) was up 11%.

Fourth quarter 2022 was up 8%.

Fourth quarter 2021 was up 12%.

Fourth quarter 2020 was up 12%.

We have a big jobs report on Friday.

As we discussed in my last note, the result of the Fed’s very restrictive policy rate has been damage to the labor market.

That damage has been revealed in the rate-of-change at which the unemployment rate is rising.  It’s at a speed that is consistent with the past four recessions.

And with that, the weak jobs data that was reported early last month (Aug. 2) was the signal to markets that the Fed had arrogantly held rates too high, for too long — and that perhaps aggressive rate cuts were coming, as the Fed finds itself cleaning up another policy mistake.

What else was revealed that day?

The Fed’s stubbornly hawkish policy over the past two-and-a-half years has created a vulnerability in global markets.

It was the persistent telegraphing by the Fed of high and stable relative interest rates in the U.S., that attracted capital from around the world, particularly from Japan (where investors borrowed yen cheaply, and invested in higher yielding and high return U.S. assets … i.e. “the carry trade”).

With that, we looked at this chart heading into that jobs report last month (from my July 25 note) and talked about the prospects of that trade reversing …

In this chart, you can see the dollar/yen exchange rate in purple, and the Nasdaq in orange. 

As you can also see the two have, no coincidence, tracked closely. 

The story of this chart above is 1) borrowing yen for (effectively) free, 2) converting that yen to dollars (dollar/yen goes up), and 3) investing those dollars in the highest quality dollar-denominated assets (U.S. Treasuries and the big tech oligopoly stocks).

As we know, the weak labor market picture early last month did indeed trigger a sharp unwind of this trade.  

And here is the update of this chart …

While stocks have made a full V-shaped recovery since that sharp unwind, USDJPY has not.

And with another check-up on the health of the job market coming down the pike this week, this divergence (within the white box in the chart above) looks likely to close in the direction of the purple line (i.e. stocks lower). 

Tomorrow, we get the July PCE report (personal consumption expenditures).

This is the inflation measure the Fed cares most about.  It’s the basis of their 2% inflation target (headline PCE).

The consensus view for the July report is a continuation of what the Fed perceives to be “a stall” at around 2.5%.

For perspective, if we take a step back and look at a longer term view of PCE, inflation running above the Fed’s target hasn’t historically resulted in the type of obsessive Fed response we’ve seen over the past year.   

As you can see in the chart below, PCE has spent plenty of time above 2%.  In fact, the average PCE dating back to 1990 is 2.22% (i.e. above target). 

As we know, this stall in PCE, around 2.5%, has led the Fed to continue holding the policy rate at historically tight levels.  

How tight? 

If we subtract 2.5% (PCE) from 5.33% (Fed Funds Effective Rate), we get a real interest rate of 2.83%. What was the average real rate over the period on this chart above?  It was 0.6%.  The decade prior to the global financial crisis was just 1.73%.

So clearly the current real interest rate is historically very restrictive policy.  

And with that, the result has been damage to the labor market.  As we’ve discussed, while the unemployment rate remains low, the speed of change in the unemployment rate puts it in unique company of the past four recessions. 

So tomorrow’s inflation report should be an uneventful one.  The big event will be next Friday’s unemployment report. 

Today we heard earnings from Nvidia, the most important company in the world.

The state of the new industrial revolution is well intact. 

But we already knew that.  We heard last month from all of the tech giants that are working on the frontier of generative AI (Microsoft, Amazon, Tesla, Meta, Alphabet).

And they told us, 1) the price to build generative AI computing capacity continues to go up … 2) they will spend whatever it takes on the infrastructure … 3) the AI model intelligence continues to rapidly advance, and … 4) the stage of the technology revolution is still very “early.“

So, given that they are all buying as many GPUs from Nvidia (the gold standard) as the company can produce, it was fair to expect another good report from Nvidia. 

With that, for Q2, Nvidia reported this afternoon.  And it was the fifth consecutive quarter of triple-digit year-over-year revenue growth.