Wall Street faces Fed in fight that could send stocks tumbling
- Wall Street and the Fed are at an impasse, and the solution will almost surely hurt investors.
- Stocks have recently jumped on hopes that the central bank will start cutting rates in 2023.
- But Fed officials made it clear that the bullish cycle is far from over.
Wall Street and the Federal Reserve clash again. The latter will almost certainly win, which will likely mean financial hardship for investors.
The Fed is far from having finished its fight against inflation. Prices are still rising at the fastest rate in four decades, and officials have hinted that several more interest rate hikes are due before the end of the year. Wall Street, however, is not buying it. Investors are betting that the central bank will reverse course within a year, hanging their bets on recent comments from the Fed that they see as signs of a pullback.
The fight began on July 27. After raising interest rates another 0.75 percentage points, the central bank signaled that it may soon deviate from the fastest rising cycle since the 1980s. It “will probably become appropriate” to slow down the pace of Fed increases as interest rates begin to constrain the economy and growth slows, Chairman Jerome Powell told a news conference.
The change was music to investors’ ears. The hawkish pace of rise has sent equities tumbling through 2022 as higher rates make borrowing more expensive and, in turn, increase corporate debt burdens. Investors took Powell’s comments as a dovish tilt and quickly offered higher prices. The S&P 500 jumped nearly 4% in Wednesday and Thursday trading sessions, and the benchmark is now at its highest level since early June.
The rally, while encouraging for investors, runs counter to the Fed’s own objectives. The central bank’s rate hikes aim to calm inflation by tightening financial conditions broadly. Yet the market reaction to the July press conference explicitly relaxed those conditions. Stocks rose, Treasury yields fell and borrowing costs fell. A Bloomberg index of U.S. financial conditions shows the economy is enjoying looser conditions than seen in March, when the Fed began raising rates from historic lows.
This risks nullifying the central bank’s efforts to fight inflation. Rising stock prices and cheaper borrowing are encouraging Americans to spend more. This threatens to widen the gap between supply and demand and keep inflation at its highest level in 40 years.
Fed officials were quick to set the record straight. Projections that the Fed will significantly slow its rate hikes and start cutting rates in 2023 are “a headache for me,” San Francisco Fed Chair Mary Daly said in an interview Tuesday with Jon Fortt. from CNBC, adding the central bank’s bullish cycle. is “far from almost finished”.
“We’ve gotten off to a good start and I’m really happy with where we’ve gotten to this stage,” she said.
Chicago Fed President Charles Evans echoed his colleague’s comments on Tuesday. A half-point hike at the Fed’s September meeting “is a reasonable assessment,” but another three-quarter point hike “could also be acceptable,” he said. Still, it will take time and more data to know “if we have much more ahead of us,” he added.
Neither Evans nor Daly are voting on the Federal Open Market Committee this year, meaning they have no say in central bank rate setting. Yet their comments mark a significant pushback against the market rally and a healthy reminder that the Fed’s fight against inflation is far from over.
The disconnect between the markets and the Fed’s mission could lead to a bad hangover for investors. If financial conditions continue to ease, the central bank will likely need to be more hawkish in order to calm inflation. The abandonment of what the markets perceive as a dovish stance will likely result in a selloff as investors prepare for a continuation of the aggressive bull cycle. Without such a reversal, financial conditions will remain exactly the opposite of what the Fed is aiming for.
“This series of Fed speeches suggests that markets may be a little too optimistic about pricing a Fed pivot and that calls for lower rates for next year are too optimistic,” he said. Edward Moya, senior market analyst at OANDA, in a Tuesday note.