Stocks explode. Will recent market declines dampen the Fed?
The stock market has predicted nine of the last five recessions, economist Paul Samuelson joked in the 1960s. Half a century later, is the stock market pushing the economy down?
Falling stock prices could push business leaders to cut spending and hiring, which would dampen the economy. That, in turn, could reduce the need for the Federal Reserve to raise interest rates as much as it feared. The central bank, it is thought, could actually ease monetary policy by the end of 2023.
At least, that seems to be the logic of the markets over the past week. Strong rallies in credit markets followed a marked easing in the prices of key commodities, including crude oil and key metals such as copper. In turn, stocks snapped their three-week losing streak with gains ranging from 5.4% on the
Dow Jones Industrial Average
at 7.5% for the
split the difference with a 6.4% lead.
The bullish market action unfolded incongruously amid overwhelmingly negative sentiment towards the economy. The latest University of Michigan survey released on Friday recorded the most pessimistic readings on record, with inflation expectations still high.
Those subjective feelings matter because Fed Chairman Jerome Powell said they influenced the central bank’s decision to raise its main target federal funds rate by 0.75 percentage points earlier this month. , the biggest rise since 1994, to a target range of 1.5% to 1.75%.
People are expecting a recession because the highest inflation in decades will force the Fed to tighten enough to push the economy into a slowdown, observes Ed Hyman, head of Evercore ISI and still top-rated economist of Wall Street.
How high is it? It could be 4%, or 5%, or 3%, he said in a phone interview. Its level will depend on when inflation starts to improve. “Better” is a subjective term, but Hyman said we’ll know when we see it.
Signals that inflation and interest rates could peak sooner came from the commodity and credit markets. Dr. Copper, as the metal is called for having a doctorate. in economics due to its forecasting prowess, plunged 6% last week, settling just above its one-year low on Thursday, and is down 16% over the past three weeks.
These recessionary ripples were felt in the Treasury market, where yields fell sharply from recent highs. After touching 3.48% in the penultimate week, the benchmark 10-year note traded as low as 3.02% before ending the week at 3.13%. The two-year note, the coupon maturity most sensitive to Fed rate expectations, fell from a high of 3.44% to 2.89% last week, before ending Friday at 3.06 %.
These sharp declines in yield reflect a substantial recalibration of expected future central bank policies. Eurodollar interest rate futures implicitly price in further Fed rate hikes through the end of the year, but on a pivot by the second half of 2023, implying a sufficient improvement in inflation by then to subside.
If inflationary pressures peak, thank the stock market, according to Doug Ramsey, chief investment officer of the Leuthold Group. “Major” declines in the S&P 500 – which it found at 19% based on data for the past 55 years, just short of the arbitrary 20% definition of a bear market – have “generally triggered a powerful impulse disinflationary,” Ramsey wrote in a client note.
While Powell claimed the economy can handle tougher Fed policy, the stock market cannot, according to Macro Intelligence 2 Partners. CEOs will react to failing stocks, leading to cuts reflected in metrics such as purchasing manager surveys or employment barometers. The research note recommends betting on future Fed easing by buying December 2023 Eurodollar futures, which rise when rates fall.
This suggests a significant gap between the Fed’s words and the market’s expectations for its future actions. In his semiannual testimony to Congress on Politics and Economics, Powell reiterated the central bank’s intention to bring inflation back to its 2% target. The Fed’s latest economic projections indicate that this will be accomplished over the next two years with only a slight increase in unemployment.
The bond market expects the Fed to be less drastic if inflation falls sufficiently, while at the same time the labor market weakens next year. In turn, equity investors saw the weak outlook for really tight credit as reason enough to quell their pessimism last week.
In sum, the markets perceive that Powell & Co. will not plunge the economy into a deep recession to bring inflation back to the desired target. Given disinflationary signals from bonds and commodities, fed funds futures are pricing in a peak of 3.5% to 3.75% reached mid-next year, below projections of 3.8% Fed policymakers at the end of 2023.
As Hyman observes, we will know when the Fed has done enough when we see it. But that will likely mean waiting for a later recession to return to 2% inflation, if ever.
Write to Randall W. Forsyth at [email protected]