Market Turns Optimistic on Growth - What to Watch for Next

Ever hear someone say: "Well, the market is telling us that the economy is going to do this or that"? 

Well, the market was giving us a very clear signal Friday, potentially making stocks vulnerable right now. 

What's Happening?

President Trump said he is considering extending a "partial" trade agreement proposal to Chinese leader Xi Jinping. This comes after China struck a more conciliatory tone in recent comments from its Finance Ministry. Plus, China said it will exclude soybeans and pork from its current list of tariffed items coming into China from the U.S. Ever since Trump and Xi agreed to meet in October to talk trade, investors have priced in optimism that a trade deal will eventually be reached. 

What's the Market Doing?

So the S&P 500 rose as much as 0.3% Friday, before that gain moderated to a flat intraday move by the end of the day. Investors are getting more optimistic that, with some tariffs potentially removed, some economic drag will be removed from the equation. Importantly, the U.S. economy is still decelerating independent of the trade war. 

As this breeze of optimism about growth blew into the market, the benchmark 10-year treasury yield rose as investors fled bond (bond prices move inverse to yields). The 10-year yield rose to 1.87%, up from 1.55% a few days ago. Meanwhile, the 3-month treasury yield fell to 1.98%. The inversion between the 3-month and 10-year treasuries is now less deep than it was several days ago, another incremental "risk on" signal. 

This indicates the market is pricing in a slightly lower probability of two Federal Reserve interest rate cuts, both of which may not be necessary should the economy's deceleration moderate on better trade relations. The chances of two rate cuts stand at 88%, according to data from the CME Group, down slightly from a few days ago. 

As yields rose, so did bank stocks, which partly rely on their net interest margin (borrowing short term in order to lend long-term) for stronger profits. Bank of America (BAC - Get Report) rose 1.6%. Wells Fargo (WFC - Get Report) rose 0.48%. JPMorgan (JPM - Get Report) rose 1.78%. 

The Risk in Stocks Going Forward

Simply put, the Fed may not cut rates twice, which the stock market is still pricing in, with the S&P 500 up 20% year-to-date. If Fed Chairman Jerome Powell announces in 2019 there won't be two cuts, stocks will likely fall. Many on Wall Street have said lower rates (slightly higher Friday) are merely "supportive" of equities at the market's current level, rather than stimulative. The economic drag created by the trade war, as businesses uncertain about the future invest and hire less, would outweigh the positive impact of lower rates, many have said. 

The market may need that support level. 

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