The Fed is cooling the economy, but stocks are hot. Which give?


Stocks have rebounded from their June low as investors bet inflation has peaked, even as the Federal Reserve signals its campaign to cool the economy by raising interest rates is not finished.

Higher interest rates are generally seen as bad for stock prices because they increase costs for businesses. A chorus of Fed officials recently insisted that the central bank will have to push interest rates even higher to curb stubbornly high inflation. Still, the S&P 500 is on an upward march, posting gains over the past three weeks and rising more than 12% from its June 16 low.

Rather than worry that a warm economy might embolden the Fed to raise rates more aggressively, investors appear to be choosing to focus on easing recession fears, particularly as many expect the pace inflation is starting to slow.

A big test of that thinking will come on Wednesday, with the release of the latest Consumer Price Index data. The widely watched report is expected to show that headline inflation moderated in July, according to a survey of economists from Bloomberg, up 8.7% from a year earlier, from a pace of 9.1% in June.

Over the past few weeks, a series of better-than-expected quarterly corporate earnings reports have helped support investors. New data on Friday showed U.S. businesses continued to hire new employees at a healthy pace last month, a sign the economy has proven resilient to rising interest rates. But it could also be seen as a sign that the Fed needs to do more to cool the economy and lower prices, raising the risk that higher rates could tip the economy into a recession.

“I think the ‘spike inflation’ argument has become so entrenched in the market psyche that the jobs report has been interpreted more as recession-proof,” said David Donabedian, chief investment officer of CIBC Private Wealth Management.

Although investor expectations for the Fed’s main interest rate at the end of the year have risen this month, investors still expect the Fed to not only stop raising rates next year, but will have to reduce them somewhat. That’s a change from expectations in June, when investors were more closely aligned with the Fed’s own forecast that rate hikes would continue through 2023.

The Fed could lower rates next year, in the optimistic case, if it turns out that inflation has been brought under control without dragging the economy down and that tighter policy is no longer needed. A household survey released Monday by the Federal Reserve Bank of New York showed a sharp drop in consumer inflation expectations, supporting the idea that an inflationary spiral is not setting in.

But Mr Donabedian warned that investors could be overly optimistic even if inflation falls from current levels. If the headline inflation rate drops to 8.7%, that’s well above the Fed’s 2% policy target.

With such optimism fueling stock prices, any shock indicating an acceleration in inflation could quickly send financial markets lower. As a result, said Alan McKnight, chief investment officer at Regions Bank, he is “less optimistic” than the financial markets seem.

Other factors can explain seemingly confusing market movements.

August is generally a quiet month for stocks, with trading volumes dwindling as traders head away from their desks for the summer holidays, making prices more susceptible to sudden moves. Trading volume in a $375 billion exchange-traded fund that tracks the S&P 500, which trades under the symbol SPY, fell to its lowest level since November last month.

There has also recently been a re-emergence of feverish trading in ‘meme’ stocks like cinema operator AMC Entertainment, up more than 60% this month, and Bed Bath & Beyond, up more than 120%. % this month.

The combination of these trading patterns has made it even more difficult to interpret trends in financial markets – already grappling with rising inflation, rising interest rates and mounting fears of recession.

“It was an extraordinary economic environment for many reasons, wasn’t it?” said Ben Snider, market strategist at Goldman Sachs. “So it’s hard to say something is unusual or usual, because everything has been unusual recently.”

The S&P 500 has been down slightly in recent days, but the declines were modest compared to last month’s gains, suggesting investors could brace for Wednesday’s inflation numbers before making their next significant move. The index fell 0.4% on Tuesday.


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