Wall Street is making big bets that the Fed will cut interest rates next year and boost stocks — they could be in for a rude awakening
- Wall Street and the Fed are at an impasse, and the solution will almost surely hurt investors.
- Stocks recently surged on hopes that the central bank will start cutting rates in 2023.
Wall Street and the Federal Reserve are once again butting heads. The latter will almost certainly win, and that will likely mean financial pain for investors.
The Fed is nowhere close to finishing its fight against inflation. Prices are still soaring at the fastest pace in four decades, and officials have hinted that several additional interest rate increases are due before the end of the year. Wall Street, however, isn't buying it. Investors wager the central bank will reverse course within a year, hanging their bets on recent Fed comments they perceive as signs of a pullback.
The brawl started on July 27. After raising interest rates by another 0.75 percentage points, the central bank signaled it could soon pivot from the fastest hiking cycle since the 1980s. It "will likely become appropriate" to slow the Fed's pace of increases as interest rates start to restrict the economy and growth slows, Chair Jerome Powell said at a press conference.
The shift was music to investors' ears. The hawkish hiking pace pummeled stocks throughout 2022, as higher rates make borrowing more expensive and, in turn, worsen companies' debt burdens. Investors took Powell's comments as a dovish tilt and quickly bid prices higher. The S&P 500 surged almost 4% across the Wednesday and Thursday trading sessions, and the benchmark now sits at its highest level since early June.
The rally, while encouraging for investors, flies in the face of the Fed's own objectives. The central bank's rate hikes aim to cool inflation by broadly tightening financial conditions. Yet the market's reaction to the July press conference explicitly loosened those conditions. Stocks rose, Treasury yields fell, and borrowing costs eased up. A Bloomberg index of US financial conditions shows the economy enjoying looser conditions than those seen in March, when the Fed first started raising rates from historic lows.
That risks undoing the central bank's efforts to fight inflation. Rising stock values and cheaper borrowing encourages Americans to spend more. That threatens to widen the gap between supply and demand and keep inflation at 40-year highs.
Fed officials have been quick to set the record straight. Projections that the Fed will dramatically slow its rate hikes and start lowering rates in 2023 are "a puzzle to me," Mary Daly, president of the San Francisco Fed, said in a Tuesday interview with CNBC's Jon Fortt, adding the central bank's hiking cycle is "nowhere near almost done."
"We have made a good start and I feel really pleased with where we've gotten to at this point," she said.
Chicago Fed President Charles Evans echoed his colleague's remarks on Tuesday. A half-point increase at the Fed's September meeting "is a reasonable assessment," but another three-quarter-point hike "could also be ok," he said. Still, it will take some time and more data to know "if we have a lot more ahead of us," he added.
Neither Evans nor Daly vote in the Federal Open Market Committee this year, meaning they don't have a direct say in the central bank's rate-setting. Still, their comments mark a considerable pushback against the market rally and serve as a healthy reminder that the Fed's fight against inflation is far from over.
The disconnect between markets and the Fed's mission could result in a nasty hangover for investors. Should financial conditions continue to loosen, the central bank will likely have to be more hawkish in order to cool inflation. The shift away from what markets perceived as dovishness will likely lead to a significant selloff as investors brace for the aggressive hiking cycle to continue. Without such a reversal, financial conditions will remain the exact opposite of what the Fed is aiming for.
"This round of Fed speak suggests markets might be a little too optimistic into pricing in a Fed pivot and that rate cut calls for next year are too optimistic," Edward Moya, a senior market analyst at OANDA, said in a Tuesday note.
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