NEW YORK, April 7 (Reuters) – A closely watched U.S. inflation report next week could help settle one of Wall Street’s most pressing questions: whether the market has correctly pegged the near-term path for interest rates.
After last month̵[ads1]7;s banking crisis, investors have become more convinced that the Federal Reserve will cut interest rates in the second half of the year to stave off an economic downturn. Such bets have pushed bond yields lower, supporting the giant technology and growth stocks that have sway over broad stock indexes. The S&P 500 (.SPX) is up 6.9% so far in 2023.
But the central bank’s more restrictive interest rate outlook sees borrowing costs remaining around current levels through 2023. That view could gain support if next week’s inflation reading shows a strong rise in consumer prices even after aggressive Fed rate hikes over the past year.
“If (the CPI) comes in, investors will start pricing interest rates closer to where the Fed is and likely push asset prices,” said Tom Hainlin, national investment strategist at US Bank Wealth Management. The firm recommends that clients be somewhat underweight in shares, and expects that interest rate increases will affect consumer spending and corporate profits.
US employment data for March, released on Friday, showed signs of continued tightness in the labor market that could prompt the Fed to raise interest rates again next month.
Recession worries are mounting, and investors are betting that the turmoil in the banking system triggered by the collapse of Silicon Valley Bank in March will tighten credit conditions and hurt growth.
In the bond market, the Fed’s preferred recession indicator has plunged to new lows in the past week, which strengthens the case for those who believe the central bank will soon have to cut interest rates. The measure compares today’s implicit forward rate on treasury bills 18 months from now with the current yield on a three-month treasury bill.
Pricing in futures markets shows that investors are betting that central bank easing later this year will lower the Fed Funds rate from 4.75% to 5% currently to around 4.3% by the end of the year. Nevertheless, estimates from Fed politicians show that most expect no interest rate cut before 2024.
“Financial markets and the Federal Reserve are reading from two different playbooks,” strategists at LPL Research said in a note earlier this week.
Bets on a more dovish Fed have boosted technology and growth stocks, whose future earnings are discounted less when interest rates fall. The S&P 500 technology sector (.SPLRCT) is up 6.7% since March 8, more than double the overall index over that time.
Economists polled by Reuters expect March data, due on April 12, to show the consumer price index rose 5.2% year-on-year, down from 6% the previous month.
Markets will also watch first-quarter earnings, which start in the coming week with major banks including JPMorgan and Citigroup due on Friday. Analysts expect S&P 500 earnings to fall 5.2% in the first quarter from the same period last year, I/B/E/S data from Refinitiv showed.
For some investors, the Fed’s recent interventions to stabilize the banking system may have revived hopes of a so-called Fed put, said Mark Hackett, head of investment research at Nationwide, referring to expectations that the central bank will take action if stocks fall. too deep, even though it is not mandated to maintain asset prices.
“If the Fed was trying to protect investors, one way would be to cut interest rates,” Hackett said. “They haven’t yet, but the market is betting they will, rightly or wrongly.”
Still, a recession can depress stock prices, even if it forces the Fed to cut interest rates earlier. Some investors worry that stock prices have not accounted for a drop in valuations and corporate earnings that would occur during a sharp downturn.
“One need only look back to 2001 or 2008 to see that a shift in Fed policy alone is not always enough to stop an economy on a downward trajectory or start another bull market,” wrote Keith Lerner, chief investment officer at Truist Advisory Services, in a note earlier this week.
“Our view is that the market is now baking in a lot of good news and leaving little margin for error,” he said.
Reporting by Lewis Krauskopf; Additional reporting by Saqib Iqbal Ahmed and Davide Barbuscia; Editing by Ira Iosebashvili and David Gregorio
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