It’s dawning on stock investors that they got it wrong about the Federal Reserve.
Stock trading has become jittery after rebounding behind a robust economy, easing inflation and hopes that the central bank would soon end its rate hikes.
The S&P 500 is up just 1 percent in February after drifting sideways since its peak earlier in the month. Stocks fluctuated between gains and losses as fresh economic data clouded the outlook for investors, a notable shift in the market after stocks rose more than 6 percent in January.
The tone changed significantly this week as a steady flow of data showed the economy remained hot in January. Despite high-profile layoffs at big tech companies like Meta and Microsoft, employers in the United States continued to hire at a rapid pace, consumers continued to spend and prices continued to rise sharply for a range of goods and services earlier in the year.
All of these data points suggest that the economy retains significant momentum. The Fed has repeatedly warned that more needs to be done to curb rising prices, even after a year of rapid policy adjustments meant to cool the economy. Now the continued momentum has dashed hopes by some investors that inflation would steadily continue the slowdown it began towards the end of last year and allow the central bank to end its rate hikes earlier than announced.
In response, investors have sharply raised their expectations of how often the Fed will hike rates in the coming months. Central bankers themselves have begun to consider the possibility that if the economy does not cool, interest rates will have to rise higher than previously expected. Higher interest rates increase costs for consumers and businesses, slow demand and usually weigh on the stock market.
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The slump in equity and bond markets this year has been painful and it remains difficult to predict the future.
“I’m very negative on equities right now,” said Eric Johnston, head of equity derivatives at Cantor Fitzgerald, who predicted the recent S&P 500 rally but now expects a slump. “I think the movement we’ve seen in the rates market, some of the inflation numbers that have been released and the expectation that the economy will be fine are all quite problematic.”
Mr. Johnston now believes the S&P 500 will eventually fall below its 2022 low, down about 15 percent from current levels. Strategists at Morgan Stanley and JPMorgan Chase are also preparing for a crash.
Bond investors had changed their minds faster.
Earlier this month investors who bet on interest rates predicted the Fed would raise interest rates just once more this year, by a quarter of a point in March.
Now those traders are forecasting three hikes of that magnitude through July, which would put the Fed’s interest rate in a 5.25 to 5.5 percent range. That’s above the Fed’s most recent forecast, released in December.
However, policymakers have also hinted that their own estimates could be revised if the economy continues to run hotter than previously thought.
John C. Williams, president of the powerful Federal Reserve Bank of New York, hinted this week that interest rates were likely to rise to a range of 5 to 5.5 percent — slightly above the median of 5 to 5.25 percent in the US Central bank forecast for December. He and several of his colleagues have said they may need to do more if consumption and the labor market remain resilient.
“Given the strength in the job market, there is a clear risk that inflation will remain high longer than expected or that we may have to raise rates even more,” Williams told reporters in New York this week.
Loretta Mester, the president of the Federal Reserve Bank of Cleveland, said during a speech Thursday that “we may have to go up, hold that peak for longer, or even change what we’re doing at a given meeting” if it’s economically der Pressure kept inflation high.
For investors, this still-aggressive stance has reignited fears that the Fed’s campaign will push the economy into a downturn. It’s a reversal from the more optimistic view that took hold in financial markets earlier in the year that inflation could fall while the economy continues to grow.
“We had just become familiar with what the Fed told us two weeks ago, and now we have to reconsider that,” said David Donabedian, CIBC Private Wealth US’s chief investment officer, referring to the recent Fed meet. “The momentum in the market has stopped.”
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