Markets are betting that the economy can withstand higher Fed rates

Data: fact set; Diagram: Axios Visuals

The Federal Reserve will have to raise interest rates further to cool down inflation. But the economy and corporate earnings are resilient enough to hold up anyway.

The Intrigue: Bond yields have risen sharply this month, reflecting expectations that the Fed will hike rates more than previously thought. During the same period, the prices of stocks and other risky assets remained roughly flat.

• This is in contrast to last year when there was a strong correlation between the prospect of tighter money and a sell-off in stock markets.

Why it matters: Markets are betting that the economy will remain resilient in the face of further interest rate hikes, while over the past year the feeling has been that tightening would inevitably trigger a recession.

Where it says: Fixed income movements this month have been rapid, reflecting the possibility that the Fed will need to hike further to cool the economy. For example, the market is no longer fully pricing in that the Fed will cut rates this year.

• It follows a blockbuster jobs report two weeks ago and hot reports this week on consumer and producer prices and retail sales.
• Yesterday, two Fed officials — Cleveland Fed Chair Loretta Mester and St. Louis Fed Jim Bullard — suggested that they might have preferred to hike rates by half a percentage point at the Feb. 1 monetary policy meeting , not by the quarter point that the committee endorsed.

Using the numbers: Take a look at the two-year US Treasury yields, which are the most sensitive to monetary policy changes. On February 1, the two-year lending rate was 4.19%. This morning it was at 4.68%.

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

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

• The current pattern – with markets accepting that higher interest rates will last longer without actually tightening financial conditions – raises questions about the effectiveness of the Fed’s anti-inflation tools.
• If financial markets and consumer spending remain buoyant in the face of higher interest rates, it raises the prospect of a more difficult path to bringing down inflation than has become popular belief.

What you say: “An economy that is growing rapidly is not inherently problematic, but elevated inflation, caused by unanchored inflation expectations, could emerge if growth continues,” Tuan Nguyen, US economist at RSM, said in a statement.

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