What’s next for stocks as investors realize Fed’s inflation fight won’t end soon

The stock market is ending February on a decidedly wobbly note, raising doubts about the durability of an early 2023 rally.

Blame stronger-than-expected economic data and hotter-than-expected inflation readings that have forced investors to again rethink their expectations around how high the Federal Reserve will drive interest rates.

“The idea that equity markets would experience a strong upside surge while the Fed was still hiking and the market was underestimating what Fed was going to do” had looked “untenable,” said Lauren Goodwin, economist and portfolio strategist at New York Life Investments, in a phone interview.

Market participants have come round to the Fed’s way of thinking. At the end of January, fed-funds futures reflected expectations the Fed’s benchmark interest rate would peak below 5% despite the central bank’s own forecast for a peak in the 5% to 5.25% range. Moreover, the market was forecasting the Fed would deliver more than one cut by year-end.

That view began to shift after the release of a January jobs report on Feb. 3 that showed the U.S. economy added a much larger-than-expected 517,000 jobs and showed a drop in the unemployment rate to 3.4% — its lowest since 1969. Throw in hotter-than-expected January consumer and producer price index readings and Friday’s bounce in the core personal consumption expenditures price index, the Fed’s favored inflation measure, and the market’s outlook on rates looks much different.

Participants now see the Fed raising rates above 5% and holding them there through at least year end. The question now is whether the Fed will bump up its forecast of where it expects rates to peak at its next policy meeting in March.

That’s translated in a backup in Treasury yields and a pullback by stocks, with the S&P 500 down around 5% from its 2023 high set on Feb. 2, leaving it up 3.4% in the year to date through Friday.

It isn’t just that investors are learning to live with the Fed’s expectation for rates, it’s that investors are realizing that…


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