Let's start with what happened to markets after the Fed's rate cut yesterday. It wasn't pretty. The Dow dropped 1,100 points. The S&P fell 3%. The Nasdaq dropped 3.5%. The Russell 2000 small-caps fell 4.4%. And the 10-year yield surged, pushing mortgage rates back above 7% today.
Why such a bad reaction to a rate cut? It wasn't the cut itself. It was the Fed's updated projections on future rate cuts. They're now expecting, on average, just two more cuts next year. The market was still expecting three. Boom! There's your selloff.
Both growth and inflation have come in firmer than expected since the Fed's half-point cut back in September. As a result, the 10-year Treasury yield has risen from 3.6% before that rate cut to 4.56% as of this morning. The "good" news is that's un-inverted the yield curve, a promising sign for banks to do more lending and support the economy into next year.
But there is plenty of not-so-good news about this, too. For one, no one wants stickier inflation. The 10-year "TIPS" yield, an inflation proxy, has been spiking in recent days, and especially after the Fed's rate cut yesterday. It's gone from 1.9% two weeks ago, to 2.22% this morning. It's only been higher twice in recent years; earlier this summer, and in late 2023.
When inflation expectations spike, it's a headwind for the broader market, as Barry Knapp of Ironsides Macro explains. It tends to favor outperformance of the "Mag 7," or any mega-cap tech stocks, over the rest of the market. It's why the equal-weight S&P 500 has been lagging of late. It's why the Russells did so poorly yesterday. Only the growthiest of the growthy names can thrive when rates and inflation are high.
And then there's the fiscal problem. High rates are, to put it mildly, a disaster for the budget. Recall, $900 billion of our $1.8 trillion deficit last year went to interest payments on the debt. Because we can't cancel the debt, the only way to lessen that figure (and to stop adding to the $36 trillion debt pile) is to bring rates down meaningfully. That's clearly not happening right now.
The "bond vigilantes," a nickname for traders who have been pushing up yields, "have been signaling concerns over several areas: 1) inflation, 2) deficits, and 3) tariffs and tax cuts," wrote our Bob Pisani. Now, he cautions, "the stock market is catching up with the bond market."
Layer on top of that yesterday the arrival of what Dan Clifton of Baird (who will join us on the show today) calls "the ultimate bond vigilante"--Elon Musk. Musk and Vivek Ramaswamy were lobbying hard on X against the 1500-page bill that would avoid a government shutdown at midnight Friday and fund the government through March. The reason? Too many non-core spending projects, like $3 billion for a new NFL stadium in D.C.
Musk, in other words, is trying to do what bond vigilantes have tried with mixed success over the years to do--push Washington to meaningfully bend the cost curve. With respect to James Carville, who once joked he wanted to be reincarnated as the bond market in order to intimidate everybody, Musk seems to have even more power than the vigilantes now.
And in an ironic twist, President-elect Trump last night weighed in not only to back their calls to sink the existing bill, but to add a twist: he wants lawmakers to also raise the debt ceiling, which he'd otherwise hit sometime next year.
Little wonder both bond and stock markets are a little freaked out. The post-election honeymoon period is now giving way to a new focus on how exactly the new administration's goals will play out.