The U.S. bond market blinked.
It took a while, but Federal Reserve Chair Jerome Powell has prevailed in a contest that for a while saw traders refuse to price in a higher and longer-lasting rise in interest rates in 2023. The capitulation has also lifted the U.S. dollar and in turn put a lid on commodity prices.
But it hasn’t rattled a stock market that’s enjoyed a strong bounce to start the year. Investors wonder whether that can last.
Flash back to the conclusion of the Fed’s policy meeting on Feb. 1. Powell warned — and repeated the message the following week — that the Fed was set to raise the fed-funds rate above 5% and keep it there in 2023. But fed-funds futures traders saw it peaking below 5% and had priced in rate cuts by year-end.
Then a run of economic data began to flow in. A red-hot January jobs report on Feb. 3 was followed by Tuesday’s consumer-price index reading that showed inflation continued to slow but was proving sticky in important areas. Wednesday delivered a much stronger-than-expected January retail sales reading.
A producer-price index reading for January on Thursday also came in hotter than expected.
And Cleveland Fed President Loretta Mester, who isn’t a voting member of the rate-setting Federal Open Market Committee this year, said she had seen a “compelling” case to lift the fed-funds rate by half a percentage point at the last meeting, when the Fed delivered a quarter-point rise.
It all affirmed the notion of an economy running stronger than expected and requiring the Fed to do what it said it would do in its effort to bring inflation down to its 2% target.
Fed fund futures are now pricing in a better-than-50% probability “for a June rate hike, meaning the terminal rate would be 5.375%. There was virtually 0% chance of a June rate hike three weeks ago,” noted Tom Essaye, founder of Sevens Report Research, in a Thursday note ahead of economic data and Mester’s remarks. Expectations for rate cuts by year-end have largely evaporated.
Treasurys have sold off, sending yields jumping, particularly at the short end as investors price out expectations for near-term cuts. The yield on 6-month Trasury bills
this week moved above 5% for the first time since 2007, while the 2-year Treasury yield
is trading at its highest since November and the 10-year Treasury yield
rose to a new-year high.
Stocks have felt some pressure, with major indexes losing ground last week, but a 2023 rally remains solidly intact. What’s more, technology and other growth stocks that tend to be more sensitive to rising rate expectations and an increase in Treasury yields, have outperformed the broader market.
Read: ‘Underlying bullish tenor’: U.S. stocks fare surprisingly well as Treasury yields rise after hotter-than-expected inflation, says Morgan Stanley’s Andrew Slimmon
While stocks were lower on Thursday, the tech-heavy Nasdaq Composite
remained on track for a 2.5% weekly gain, while the S&P 500
and Dow Jones Industrial Average
were also positive on the week.
The stock market has been “sanguine, if not positive, in its reaction,” said Quincy Krosby, chief global strategist at LPL Financial.
That resilience, analysts said, may speak to the idea that recent data give investors faith that the economy can withstand more aggressive Fed rate hikes. Confidence appears to be growing in the prospect of avoiding a so-called hard landing for the economy, in favor of a “soft landing,” or modest slowdown, or even averting a slowdown altogether in what economists are terming a “no landing” scenario.
Some market watchers see equity bulls headed for a comeuppance. Rising short-Treasury yields are closing the gap with the S&P 500 dividend yield, making riskier equities less attractive.
See: Stocks face ‘meaningful’ downside risk amid ‘complacent’ markets: JPMorgan
And a no-landing scenario could spell trouble because it would mean the Fed would have to lift rates even higher than Fed policy makers and market participants now expect.
Read: Top Wall St. economist says ‘no landing’ scenario could trigger another tech-led stock-market selloff
Strong data reinforces expectations the Fed will raise its forecast for where it expects the fed-funds rate to peak. The December Summary of Economic Projections, known as the dot plot because it plots out individual policy maker expectations for the rate path, indicated a peak just above 5%. The dot-plot is due to be updated when policy makers meet in March.
Krosby said the market outlook may be facing an important transition,
“The message from the market has been, overall, that cyclical sectors, including technology, can continue to lead the market higher even with higher rates, as long as the market is underpinned by stronger economic growth,” Krosby said.
What would be a sign that stock-market investors are losing faith?
“If the cyclical focus reverts to a more defensive posture, with consumer staples beginning to lead once again, the message will be clear that expectations are inching higher for a marked economic downturn,” Krosby wrote.