The scorching US economy disrupts the market’s narrative of expecting Federal Reserve rate cuts.

Strong US economic data is presenting investors with an unexpected dilemma: can robust growth continue to propel stocks higher even if the Federal Reserve implements less monetary policy easing than initially anticipated?

Anticipation of a Fed shift towards rate cuts led to a surge in stocks towards the end of 2023, culminating in a record high for the S&P 500 in January. Despite a 4% increase this year and a remarkable 24% surge in 2023, this narrative has been challenged by indications that the economy may be overheating, making rate cuts a risky move that could trigger inflation. The recent stellar US employment report further dampened hopes of imminent rate cuts, following remarks from Fed Chairman Jerome Powell suggesting no immediate policy adjustments.

Matthew Miskin, co-chief investment strategist at John Hancock Investment Management, remarked, “The anticipated Fed pivot that drove the fourth-quarter rally and recent stock surge is dissipating before our eyes.”

Following the jobs data, market expectations for a near-term rate cut have diminished, with futures tied to the Fed’s main policy rate indicating a 70% chance of a rate reduction at its May 1 meeting, down from over 90% previously. The probability of a March cut has dropped to about 20%. Seema Shah, chief global strategist at Principal Asset Management, noted that the market’s earlier pricing in of six or seven rate cuts now seems misplaced.

The robust jobs report revealed a significant increase in nonfarm payrolls, well above economists’ expectations, alongside upward revisions for November and December. Many investors view this strong growth positively, particularly when coupled with better-than-expected corporate earnings, exemplified by the S&P 500’s fresh high after the jobs data release, propelled by notable performances from Meta Platforms and Amazon.

Despite the optimistic outlook, concerns about a potential inflationary rebound persist. Russell Price, chief economist at Ameriprise, cautioned that strong wage growth could fuel inflation pressures if sustained.

Furthermore, prolonged above-trend growth could heighten stress in areas of the economy already under pressure, such as commercial real estate. Shares of New York Community Bancorp, a significant CRE lender, have declined recently, sparking broader concerns within the regional banking sector.

Expectations of rates remaining at current levels for an extended period may also lead to increased Treasury yields, potentially pressuring equities. The benchmark 10-year Treasury yield reached 4.05% on Friday, prompting investors to reconsider their expectations for Fed cuts. Despite some adjustments, investors still anticipate more rate cuts than the Fed has projected, suggesting ongoing uncertainty about the future trajectory of monetary policy.

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