Core inflation came in cool. The Dow still closed 443 points lower

For much of Wednesday the market got exactly what it had been asking for all month: an inflation print that undercut expectations, and a Fed meeting four weeks away that suddenly looked far less likely to deliver another rate increase. The S&P 500 was up 0.7% at its best level of the session; the Nasdaq Composite was up 1.2%.

Then the bond market reminded everyone who has been running this tape since early September.

The Dow Jones Industrial Average finished Wednesday down 443.87 points, or 0.86%, at 50,906.05. The S&P 500 lost 19.30 points, or 0.25%, to close at 7,651.54. Only the Nasdaq Composite held a gain, adding 63.52 points, or 0.24%, to 26,861.06, carried by megacap technology names that were higher for most of the day.

The print that started the rally

At 8:30 a.m. ET the Bureau of Economic Analysis released August personal income and outlays, which contains the personal consumption expenditures price index — the gauge the Fed targets. Headline PCE rose 0.3% on the month and 3.4% from a year earlier; core PCE rose 0.2% and 3.0%. Economists surveyed by Dow Jones expected 0.3% and 3.7% on headline, 0.3% and 3.3% on core.

The revision buried inside the report mattered as much as the new data. July's core reading was cut from 3.3% to 3.0% — and 3.3% was the number the Fed had in hand when it raised rates on September 1. Five weeks later, the inflation backdrop that justified that hike partially disappeared into a data revision.

Rate-hike pricing moved immediately. CME's FedWatch tool, which converts fed funds futures into implied probabilities, had priced a 70.9% chance of a quarter-point increase at the October 28 meeting a week ago. By Tuesday afternoon, after New York Fed President John Williams said there was 'no need for urgency,' that was close to a coin flip. After Wednesday's report, the widely cited read was about 37% for a hike and 62.9% for a hold; FXStreet put the hike probability at 34.87% and Phemex cited 47.1% later in the session. The exact figure depends on the snapshot, but the direction is not in dispute.

Goldman Sachs pushed its forecast for the next increase from October to December and warned the tightening cycle may already be finished. Futures still price a hike by the December 9 meeting as a near certainty.

Why the tape turned anyway

The reason stocks gave it back sits in the second half of the same data dump. The BEA's third estimate put second-quarter GDP growth at 2.2%, revised up on stronger consumer and government spending. August consumer spending rose 0.9% in nominal terms and 0.6% in real terms while personal income rose just 0.2% — households spent about four times as fast as incomes grew, pushing the saving rate to 4.1%.

That is not a slowing economy. And for the long end of the Treasury curve, growth is the story, not next month's Fed meeting.

So the curve split. The two-year yield, which tracks Fed expectations most closely, dropped as low as about 4.83% in the morning before drifting back to roughly 4.87%-4.89%, basically unchanged from Tuesday. The 10-year yield fell as far as 5.20% on the inflation print, then reversed and closed near 5.29%, up from 5.255%-5.26% late Tuesday. The 30-year went to about 5.63%-5.64% from 5.59%.

Stocks lost ground heading into the closing bell as the two-year yield, which typically moves in step with Fed rate expectations, turned slightly higher on the day, while longer-dated yields kept climbing on expectations for solid economic growth. — Reuters, September 30

That is the mechanism in one sentence. A dovish repricing at the front end is worth something to equities; a long end that keeps cheapening on growth — and on supply and term-premium questions that have nothing to do with the October meeting — is worth more, in the other direction.

The month and the quarter, on the record

Wednesday closed September and the third quarter. For the month, the S&P 500 fell 0.45%, the Nasdaq rose 1.86% and the Dow fell 4.29% — the Dow snapping a five-month winning streak, the S&P posting its third losing month in four, the Nasdaq gaining for a second month.

For the quarter, both the S&P 500 and the Nasdaq posted their second consecutive advance and their fifth in the past six, while the Dow logged its second quarterly decline in three.

What carries into Thursday

Three things.

• The data calendar takes over. September payrolls land Friday and September CPI is not due until October 14. Wednesday's PCE report was the last one the Fed sees before it votes; the next arrives October 29, the day after the decision.
• The long end is still unanchored. A 10-year yield at 5.29% is back at levels last seen more than two decades ago, and Wednesday showed that cooler inflation alone does not bring it down.
• Breadth, not headline levels. The Nasdaq's gain came from a handful of megacaps — Amazon, Apple, Nvidia and Alphabet were each up more than 1% at one point — while most of the market fell.

For now the split is the whole story: the market that prices the Fed's next three weeks got what it wanted on Wednesday, and the market that prices the next 10 years did not care.