Wall Street struggled this week to accept the cold reality that the Federal Reserve likely won't cut interest rates any time soon. But higher-for-longer rates are far from a death knell for stocks.
Piping-hot inflation data released Tuesday proved a tough pill for traders to swallow. Stocks and bonds both sold off as investors painfully recalibrated their expectations for five to six interest rate cuts this year to align more with the Fed's projected three cuts.
Traders now largely expect the Fed to begin cutting rates in June or July, rather than at its May policy meeting, according to the CME FedWatch Tool.
Keeping rates elevated for long enough to tamp down inflation without triggering mass unemployment has been a delicate balancing act for the Fed. Chair Jerome Powell said in January that while inflation data has been encouraging, the central bank wants to see more signs of cooling prices before moving to pare rates.
While Wall Street was rattled Tuesday by the possibility of delayed rate cuts, some investors say volatility is par for the course and that delayed easing of monetary policy is not a cause for concern.
For example, Yardeni Research has pushed back against the idea that immediate rate cuts are necessary to avoid the Fed overshooting on slowing the economy. Rather, it is the Fed's tightening cycles that set off financial crises that turn into credit crunches, which then give way to economic downturns, its researchers argue.
Put simply, since the Fed, the Federal Deposit Insurance Corporation and the US Treasury stepped in last year to contain a potential financial crisis — the collapses of Silicon Valley Bank and Signature Bank that set off regional banking turmoil — the Fed's current level of tightening is not likely to trigger a recession and rock Wall Street, they say.
"Our view is that with inflation still on a moderating trend and with economic growth remaining strong, what's the rush to lower interest rates? Why mess with success?" wrote Ed Yardeni, president of Yardeni Research, in a Tuesday briefing.
Stocks wouldn't crater even if cuts were off the table completely in 2024, according to Bank of America, despite what Tuesday's losses suggest. The bank's strategists point out that roughly one-third of the S&P 500's market cap are companies that have cash on hand. As long as the Fed doesn't hike rates again (there's no official indication that the central bank is currently considering such a move), stocks could still see a strong performance this year, they say.
"No cuts could stymie a full-fledged recovery in more credit-sensitive areas," wrote BofA strategists in a note on February 9. "But we remind investors that we expected strong returns this year not because of what the Fed would do in 2024, but because of what the Fed had already accomplished from March 2022 to now."
The central bank has made notable headway in bringing down wayward inflation since starting to raise rates aggressively nearly two years ago. Consumer prices rose 3.1% for the 12 months ended this January. While that's above FactSet-polled economists' expectations of a 2.9% gain, it's still leaps and bounds below the 9.1% annual jump that inflation peaked at in June 2022.
Of course, that doesn't mean investors won't see more pain ahead.
Two of those more credit-sensitive areas are the embattled regional banking and commercial real estate sectors. Some investors are worried that regional lenders are on shaky ground after reporting lackluster quarterly results and that commercial real estate could be the next shoe to fall as office buildings remain vacant.
The Fed in January said that it's pulling the plug on its Bank Term Funding Program, established after regional banking turmoil last year to help lenders meet their liquidity needs. That means regional lenders will no longer have that crutch if they run into trouble after the program's expiration on March 11.
Economists and investors also warn that getting inflation from 3% to the Fed's elusive 2% target will likely be the toughest leg of its price-stabilizing campaign. That's because the stickiest inflation components, or areas like services and goods that are most resistant to changing market conditions, now have to come down.
"The path to 2% inflation … will not be a straight line. As such, the only thing we can count on is volatility along the way," wrote Marc Dizard, chief investment strategist at PNC Asset Management Group, in a Tuesday note.
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