NEW YORK, April 7 (Reuters) – A closely watched US inflation report next week could help clarify one of Wall Street’s most pressing questions: whether the market has correctly set the short-term interest rate path.
After last month’s banking crisis, investors have become more confident that the US Federal Reserve will cut interest rates in the second half of the year to stave off an economic downturn. Such bets have pushed down bond yields and supported the giant tech and growth stocks that dominate broad equity indices. The S&P 500 (.SPX) is up 6.9% so far in 2023.
However, the central bank’s more hawkish interest rate outlook calls for borrowing costs to remain at current levels through 2023. That view could find support if next week’s inflation readings show a sharp rise in consumer prices, even after the Fed’s aggressive rate hikes over the past year.
“If (CPI) gets hot, investors will start setting interest rates closer to the Fed and likely put pressure on asset prices,” said Tom Hainlin, national investment strategist at US Bank Wealth Management. The firm recommends clients to remain slightly underweight in equities as interest rate hikes are expected to hurt consumer spending and corporate earnings.
US payrolls data for March, released on Friday, showed signs of continued tightness in the labor market, which could prompt the Fed to hike rates again next month.
Recession fears are mounting, and investors are betting that the turmoil in the banking system sparked by the collapse of Silicon Valley Bank in March will tighten credit conditions and hurt growth.
In the bond market, the Fed’s preferred recession indicator plunged to new lows last week, adding to the case for those who believe the central bank must cut rates soon. The metric compares the current implied forward rate for 18-month Treasury bills to the current yield on a 3-month Treasury bill.
Futures market pricing shows investors are betting that central bank easing later this year will bring the fed funds rate down to 5% from the current 4.75% and to around 4.3% by the end of the year. However, forecasts by Fed policymakers show that most expect no rate cuts until 2024.
“Financial markets and the Federal Reserve are reading from two different playbooks,” strategists at LPL Research said in a statement earlier this week.
Bets on a more dovish Fed have buoyed tech and growth stocks, whose future earnings are less discounted as interest rates fall. The technology sector of the S&P 500 (.SPLRCT) is up 6.7% since March 8, more than double the overall index over the period.
Economists polled by Reuters are expecting March data due April 12 to show the CPI rose 5.2% on an annualized basis, compared with 6% the previous month.
Markets will also be watching the first quarter results, which start next week, with big banks like JPMorgan and Citigroup due on Friday. Analysts expect S&P 500 first-quarter earnings to fall 5.2% from the year-ago period, I/B/E/S data from Refinitiv showed.
For some investors, the Fed’s recent interventions to stabilize the banking system may have revived hopes of a so-called Fed put, said Mark Hackett, chief of investment research at Nationwide, citing expectations that the central bank will take action if stocks rallied falling too low despite having no mandate to sustain asset prices.
“If the Fed was trying to protect investors, one way would be to cut interest rates,” Hackett said. “They haven’t done that yet, but the market is betting that they will, rightly or wrongly.”
Still, a recession could put pressure on stock prices, even if it forces the Fed to cut rates sooner. Some investors worry that share prices are not responsible for the fall in valuations and corporate earnings that would occur during a sharp slowdown.
“One only has to look back to 2001 or 2008 to see that a change in Fed policy alone is not always enough to halt an economy on a downtrend or start a new bull market,” wrote Keith Lerner, co-chief investment Officer at Truist Advisory Services, in a note earlier this week.
“In our view, the market is now bringing in a lot of good news and leaving little room for error,” he said.
reporting by Lewis Krauskopf; Additional reporting by Saqib Iqbal Ahmed and Davide Barbuscia; Edited by Ira Iosebashvili and David Gregorio
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