Markets bet the economy can withstand higher Fed rates

Markets bet the economy can withstand higher Fed rates

Data: FactSet;  Graphic: Axios Visuals
Data: FactSet; Graphic: Axios Visuals

The Federal Reserve will have to raise rates further to curb inflation. But economic activity and corporate earnings are robust enough to hold regardless.

The plot: Bond yields rose sharply this month, reflecting expectations that the Fed will raise rates higher than previously thought. During the same period, the prices of stocks and other risky assets remained roughly stable.

  • This is a contrast to last year, when there was a close relationship between the prospect of monetary tightening and a stock market sell-off.

Why is this important: Markets are betting that the economy will remain resilient even in the face of further rate hikes, whereas last year there was more sentiment that a tightening would necessarily trigger a recession.

Where is it : Movements in the bond market this month have been swift, reflecting the possibility that the Fed will need to raise even more to cool the economy. The market, for example, no longer fully discounts the fact that the Fed will cut rates this year.

  • He comes on the heels of a hit jobs report two weeks ago and too warm for comfort reports on consumer and producer prices and retail sales this week.
  • Yesterday, two Fed officials — Cleveland Fed President Loretta Mester and the St. Louis Fed’s Jim Bullard — suggested they might have preferred to raise rates by half a percentage point at the policy meeting. February 1, not the quarter point that the committee had adopted.

By the numbers: Take a look at the yield on two-year US Treasury securities, which is the most sensitive to changes in monetary policy. On February 1, the two-year borrowing rate was 4.19%. This morning it was 4.68%.

  • In contrast, the S&P 500 over the same period is essentially flat – down 0.7%, as of yesterday’s close.

Between the lines: This is a reversal of a trend that prevailed from around November to January, when markets began pricing in Fed cuts in 2023, essentially assuming inflation will come down on its own.

  • The current trend – with markets accepting rates higher for longer, but financial conditions not tightening much as a result – raises questions about the effectiveness of the Fed’s tools in fighting inflation.
  • If financial markets and consumer spending remain buoyant in the face of higher rates, this raises the prospect of a harder path to reducing inflation than has become the prevailing view.

What they say : “A rapidly growing economy is not inherently problematic, but high inflation, caused by unanchored inflation expectations, could occur if growth continues,” Tuan Nguyen, US economist at RSM, said in a note. .

  • “The so-called no-landing scenario, in which the economy continues to grow and avoids a contraction, is not something the Fed is willing to bet on,” Nguyen wrote.

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