The stock market had an excellent month of July. Why August could be more difficult.
Stocks rallied last week as investors bet the Federal Reserve has hit its peak of hawkishness. It’s wishful thinking.
Dow Jones Industrial Average
increased by 3%, the
the index added 4.3%, and the
jumped 4.7%. All three had their best months since 2020. Even the premium paid for high yield bonds over Treasuries has narrowed significantly.
Still, it was a strange week of celebration. The U.S. economy saw consecutive quarters of declines in real gross domestic product in the first half of 2022, the Fed’s favored measure of inflation remained stubbornly high, and the central bank raised interest rates by three-quarters additional points, making it one of the fastest touring cycles of the last 40 years.
What has changed are expectations for future rate hikes, which are largely based on two sentences from Fed Chairman Jerome Powell’s press conference.
“While another unusually large increase may be appropriate at our next meeting, that’s a decision that will depend on the data we get by then,” he said. “As the monetary policy stance tightens further, it will likely become appropriate to slow the pace of increases.” Powell even said interest rates, now in a range of 2.25% to 2.5%, are likely “neutral,” meaning they’re neither accommodative nor restrictive.
The market took this message to heart. Six weeks ago, interest rate futures were in a peak federal funds rate target range of 3.75% to 4% in early 2023. Today, that peak is implied at 3.25 to 3.5% in December, just one point above the current target. Additionally, futures prices now imply two quarter-point rate cuts from February to July 2023. In other words, the market is betting that the Fed will slow the pace of its rate hikes by the end of 2023. this year, and then quickly switch to an easing policy. .
Powell’s comments on the neutral rate also angered some well-known economists and investors. Former Treasury Secretary Larry Summers called Powell’s comment on the neutral rate “indefensible,” while Pershing Square’s Bill Ackman sparked a late-night tweet storm on the subject. “While 2.25-2.25% may be a neutral rate with 2% inflation, it is an extremely accommodative rate with 9% inflation,” he wrote late Thursday evening, while self-isolating with covid-19.
The implied path for rates also looks highly unlikely – and almost certainly not good for the stock market. For it to grow, the Fed would either have to declare victory in its fight against rising prices – does anyone expect inflation to magically collapse to 2% by the end of the year ? – or completely abandon the battle to save an economy that is rapidly sinking into recession. So while the pace of tightening is slowing and inflation has peaked (famous last words, we know), this is far from a green light for investors.
With a slowing economy, still rising interest rates, and stock and bond indices near or near short-term overbought levels, it may be time to sell the rally and rebalance in higher quality or defensive areas.
“Credit spreads have continued to tighten…on a market narrative that a dovish pivot may be warranted,” Goldman Sachs chief credit strategist Lotfi Karoui wrote Thursday. “We disagree, given the likely path of inflation, and would continue to dampen the rally, using it as an opportunity to reduce risk and further increase quality.”
It’s too early to declare a Fed pivot and a green light for bullish investors. This surge in inflation will probably not be contained so easily.
Write to Nicholas Jasinski at [email protected]