Published August 2, 2024
The market tone has shifted notably this week as soft economic data pushed forward two competing narratives: 1) the Fed will almost certainly begin reducing short-term interest rates at their September meeting, 2) the economy may be softer than expected. The long-expected reduction in interest rates has been a recent boon for interest rate-sensitive stock sectors like financials, real estate, and small company stocks. But the softening economic data was read as surprising. It was the soft economic data that sent yields crashing this week and pulling stocks down with them. Furthering the slide, expensive Mag 7 stocks have largely failed to deliver earnings that would keep investors on board.
While we don’t hear much these days about the money supply, it is a very important piece of the economy. We offer the analysis below as a reminder of the value of keeping an eye on the money supply.
“One of the most crucial determinants of market behavior and economic health is the money supply. Central banks, including our Federal Reserve, manage the money supply by adjusting the monetary base, which is closely linked to the size of the Fed’s balance sheet.
To mitigate the economic impacts of COVID-19 and related government measures in 2020, the Federal Reserve significantly increased the money supply. From March 2020 to March 2022, the money supply (M2) expanded by 26% beyond its typical growth trend.
Although M2 remains above its long-term trend, the gap between the actual and the trend has been narrowing since April 2022, now reduced to just +6.5%. Notably, the year-over-year monthly growth rates declined from December 2022 through April 2024, marking the only negative growth rates since 1960. However, in the past four months, the money supply has resumed its upward trajectory. Maintaining supply growth below the long-term average of 6% will eventually realign it with the historical trendline.
During significant economic downturns, such as the 2008 Great Financial Crisis and the COVID-19 pandemic, the Fed’s policy of slashing interest rates to near zero and expanding their balance sheet can be seen as further rate cuts. Conversely, when the Fed raises rates and reduces its balance sheet, it effectively tightens the money supply, acting as an additional rate hike.
Current signals from the housing and job markets suggest that the tightening phase may have reached its limit. The 10-year Treasury yield has fallen below 4%, a decrease from 4.7% at the end of April. The Fed’s decision to halt tightening the money supply is a positive initial step, but a substantial reduction in the Fed Funds rate—beyond a mere 25 basis points—may be necessary to stabilize market conditions.”
Market Update
A big week for earnings as three of the Magnificent Seven (Mag 7) tech/consumer companies reported earnings. Also, the monthly jobs report and a flurry of other economic readings as we turn the calendar to August. Monday saw stocks holding flat ahead of all that data. Tuesday saw a resumption of the recent pullback in tech shares with the Nasdaq 100 down over 1%. Earnings results were mixed with Paypal and Stanley Black & Decker higher while Merck and Procter & Gamble fell. An about-face Wednesday with tech shares posting their best day in six months. The Nasdaq vaulted +2.6% while the S&P 500 popped +1.6%. Fueling the advance were words from Fed Chair Powell that seemed to all but promise a September interest rate cut. Recent reports of strong GDP coupled with upcoming rate cuts have been a tailwind for interest rate-sensitive stock sectors with small cap stocks essentially catching up to their bigger brethren after a furious July rally (up +10%). The Wednesday gains were all but erased Thursday, however, as a trio of economic reports surprised analysts to the downside. The weak reports coupled with the Fed’s upcoming easing sent Treasury yields tumbling which took stocks down also. The 10-year Treasury yield fell under 4% to its lowest level since late December. Then, investors were highly concerned about a near-term recession and expecting multiple Fed interest rate cuts. Now, investors have returned to that scenario, seemingly overnight. Banks, leaders in the recent rally, were hammered as the yield curve cratered with short-term rates (controlled by the Fed) now almost a full 2% above the medium term 5-year rate. Friday brought an upward thrust in unemployment on a subdued jobs report. That furthered the economic concerns leading stocks to slide further. The two-day slide whacked 3-5% off the indexes pushing the Nasdaq to a -10% slump from its peak reached one month ago. A bit lost in the gyrations were the Mag 7 earnings with Apple and Meta seeing higher share prices while Amazon slid.
The great sector rotation continued this week with volatility remaining quite high. The S&P 500 dipped -0.83% while the Nasdaq 100 plunged -2.58%. Smallcap stocks continue to be the beneficiaries of the market shift gaining +3.40% this week.
Warm wishes and until next week.