Rates: The notable reset but careful what you wish for

US stocks are paring earlier gains even as Treasury yields continue to decline amidst signs of decelerating inflation. Still, investors are growing increasingly wary about what lower inflation means for growth.

Inflation continues to show signs of decelerating in what could now be considered the 'careful what you wish for' category.

The good news is that the latest update on the third-quarter Gross Domestic Product (GDP) report indicates accelerated real growth for the economy, reaching 5.2%. Additionally, the pace of core Personal Consumption Expenditures (PCE) inflation for the same period has been revised to 2.3% from the previously reported 2.4%.

Better growth and lower inflation are a 'Goldilocks' environment for stocks; however, the third-quarter GDP report is now well in the rearview mirror, and investors are now focusing on the implications of the report and the recent run of soft US economic data for 4Q GDP growth that is simply not that favourable.

In fact, US economists are lowering the 4Q23 GDP growth forecast after the recent October trade and inventory reports -- also released overnight -- came to light, and gross domestic income rose by only 1.5% in 3Q -- well below the pace of GDP.

The decelerating inflation could indicate a broader trend – a potential slowdown in demand for the goods and services that fueled the post-pandemic economic surge. While markets were particularly nervous about runaway inflation for much of this year, they may be starting to transition their apprehensions to decelerating growth.

In the context of decreasing inflation and the possibility of slowing economic growth, yields on 10-year US Treasuries fell by another 8 basis points to reach 4.27%. Indeed, it was a notable reset, especially considering that yields began the month at a higher level of 4.90%, indicating a significant dovish sequence of events in a relatively short period.

Given the momentum behind the bond rally, it was doubtful that any upward revisions to Q3 GDP data in the US would move the macro-policy needle even more so when it was entirely overshadowed by a slight downward adjustment to the core PCE price index (to 2.3% from 2.4%).

What mattered to traders were the downward revisions to the personal spending print and the slight downtick in the core PCE reading. As mentioned above, complementing the bullish rate adjustment, wholesale inventories and trade for October printed a notable miss. That'll weigh on Q4 growth estimates.

Chris Waller's introduction of a tentative timeline on insurance cuts contingent on the evolution of the inflation figures and his rather overt remarks regarding the likelihood that policy settings are now restrictive enough to return inflation to target are all that matters right now.

Waller cemented one of the best runs for bonds since the financial crisis, and for this narrative to change, it would likely require a string of robust economic data for the current quarter or a forceful hawkish stance from other influential Fed officials. As it stands, the overarching market sentiment has distinctly shifted in favour of dovish expectations this month.

If you have been in this game long enough, you know it is hard to overstate the significance of a surprising and apparent tone shift from the Fed regarding the prospects for rate cuts in 2024.

To be sure, so-called "insurance cuts" were always on the table, and officials have not made a secret about that, so 50 bp was always a given in 2024 

So, the idea of risk management cuts certainly isn't new. Still, Chris Waller's Tuesday remarks were the most unambiguous indication that the Fed will be inclined to cut should inflation keep falling, irrespective of whether the broader economy is struggling. So, rate cuts without a recession, but now that the data is buckling, another 50 or even 100, beyond insurance cuts should not be considered out of reach. However, investors are worried about what is driving those cuts beyond the risk management insurance level, where the prospects of a recession in the next 12 months don't seem all that far-fetched.