(Bloomberg) — Investors are in for a crucial week as a key inflation indicator arrives on Tuesday and the Federal Reserve's interest rate decision on Wednesday is expected to set the tone for the stock market and economy in 2024.
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Increasing speculation that the Fed is finished raising interest rates and will begin cutting by mid-year is causing a sharp decline in Treasury yields and reviving investors' appetite for risk. The S&P 500 index has gained about $4 trillion in market value since the end of October as traders move into beaten-down market areas such as small caps, which typically benefit from falling borrowing costs.
“Stocks rallied on optimism that the Fed is done raising interest rates,” said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance. “The pricing was rational given how much 10-year yields have fallen since mid-October. It appears stocks will continue to rise through 2024.”
However, a closer look reveals concerns about the week ahead. A measure of the S&P 500's expected volatility for the next five trading sessions is rising sharply compared to the following five days. At some point this week, the gap reached its widest level for such a period since March, indicating increasing demand to hedge against turbulence.
The double whammy of crucial moments next week begins on Tuesday with the release of November's consumer price index. Signs of easing inflation could give stocks a boost as the year ends, bolstering expectations that the Fed will soon begin easing. Consumer prices likely rose 3.1% annually, the lowest since June, according to a Bloomberg survey.
The story goes on
The next day, the central bank is expected to maintain its monetary policy for the third consecutive day. With traders expecting roughly a percentage point of easing next year, they will be paying particular attention to officials' interest rate forecasts as well as Chairman Jerome Powell's news conference.
The risk is that a robust economy will keep inflation high, forcing officials to consider another hike or keeping borrowing costs high for longer than hoped. That could weigh on interest rate-sensitive technology stocks, which accounted for much of the market's gains in 2023.
“What Chairman Powell says next week could change people's minds, especially if he takes a more aggressive tone than people expect,” Zaccarelli said.
The S&P 500 has risen nearly 20% this year and closed Friday at its highest level since March 2022. Traders are hoping stocks are set for broad gains by year's end if bond yields are still falling across the board. Since Oct. 19, the 10-year Treasury yield has fallen from nearly 5% to about 4.2%, while the S&P 500 has risen nearly 8%.
Earnings drivers
History shows that sharp declines in bond yields benefit the stock market.
There have been 33 instances since 1980 when 10-year Treasury yields fell 50 basis points or more in a month, according to data compiled by Christopher Cain of Bloomberg Intelligence. The median three-month forward return for the S&P 500 was nearly 8% and for the Russell 2000 it was 8.2%.
“The nature of this bond rally is based on bets on more supportive Fed policy, which is positive for stocks,” Cain said.
Private investors seem to accept the enthusiasm. They purchased $6.8 billion worth of U.S. stocks in the week ending Wednesday, according to data compiled by Peng Cheng of JPMorgan Chase & Co. This is the largest weekly inflow since March 2022, when the Fed began its tightening cycle.
Meanwhile, many active managers who missed out on this year's rally are trying to make up for lost ground before the end of the year, adding even more momentum to equity markets. Active large-cap funds struggled to keep up with last month's rally, with just 41% outperforming their benchmark, according to Bank of America Corp. show compiled data.
“A lot of people completely failed in 2023,” said Vincent Deluard, director of global macro strategy at StoneX, noting that many investors expected a recession at the start of the year. “It was a very tough year for active managers. A lot of people got the macro picture wrong.”
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