NEW YORK, April 7 (Reuters) – Next week’s closely watched US inflation report may help settle one of Wall Street’s most pressing questions: whether the market has correctly identified the near-term path for interest rates.
After last month’s banking crisis, investors are becoming more convinced that the Fed will cut interest rates in the second half to avert an economic downturn. Those bets have pushed bond yields lower, supporting the tech giants and growth stocks that dominate broad stock indices. The S&P 500 (.SPX) is up 6.9% so far in 2023.
But the central bank’s more restrictive interest rate projections see borrowing costs remaining near current levels through 2023. This view could be supported if next week’s inflation reading shows a strong rise in consumer prices even after aggressive Fed rate increases over the past year.
“If the CPI is hot, investors will start pricing interest rates close to where the Fed is and potentially pressure asset prices,” said Tom Heinlein, national investment analyst at US Bank Wealth Management. The company advises clients to write down the value of the shares slightly, and expects the interest rate hike to impact consumer spending and corporate earnings.
US employment data for March, released on Friday, showed signs of continued labor market tightening which could prompt the Federal Reserve to raise interest rates again next month.
Divergent prospects
Recession fears are growing, as investors bet that the turmoil in the banking system sparked by the collapse of the Silicon Valley bank in March will lead to a tightening of credit conditions and hurt growth.
In the bond market, the Fed’s favorite recession indicator fell to new lows last week, boosting the case for those who believe the central bank will soon need to cut interest rates. The measure compares the current implied forward rate on a Treasury bill 18 months from now with the current yield on a three-month Treasury note.
Pricing in the futures markets shows that investors are betting that central bank easing later this year will lower the federal funds rate from 4.75% to 5% currently to around 4.3% by the end of the year. However, projections from federal policymakers show that most do not expect rate cuts until 2024.
“Financial markets and the Federal Reserve are reading from two different books,” LPL Research strategists said in a note earlier this week.
Bets on a more dovish Fed were boosted by technology and growth stocks, whose future earnings are discounted less when interest rates fall. The S&P 500 Technology Index (.SPLRCT) is up 6.7% since March 8, more than double the general index’s gains during that time.
Economists polled by Reuters expect March data, due April 12, to show the consumer price index rose 5.2% year-on-year, down from 6% the previous month.
Markets will also be watching first-quarter earnings, which start next week with major banks including JPMorgan and Citigroup on Friday. I/B/E/S data from Refinitiv showed that analysts expect the S&P 500’s earnings to decline 5.2% in the first quarter from the same period last year.
For some investors, the Fed’s recent interventions to stabilize the banking system may have revived hopes for the so-called Fed plan, said Mark Hackett, head of investment research at Nationwide, referring to expectations that the central bank will take action if stocks fall. Very deeply, although he has no mandate to maintain asset prices.
“If the Fed was trying to protect investors, one way would be to cut interest rates. They haven’t done that yet, but the market is betting that they will, rightly or wrongly,” Hackett said.
Still, a recession could put pressure on stock prices, even if it forces the Fed to cut interest rates sooner. Some investors worry that stock prices have not explained the drop in valuations and corporate earnings that may occur during a sharp downturn.
Keith Lerner, chief investment officer at Truist Advisory Services, wrote in a note earlier this week.
“Our view is that the market is now receiving a lot of good news and leaving little margin for error,” he said.
(Reporting by Louis Krauskopf) Additional reporting by Saqib Iqbal Ahmed and Davide Barbuscia. Editing by Ira Yosibashvili and David Gregorio
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