The Stock Market Wants an Easy Fed. Powell Has Other Plans.

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Traders have placed a near definite chance for the Federal Reserve to slow down its pace of interest rate hikes once again on Wednesday, when it finishes its February meeting, and then perhaps a cut later this year. The markets’ overconfidence in this scenario is emerging as one of the bigger risks.

Investors are right to be on a slower pace of rate increases. After raising rates aggressively seven times last year, the Fed in its latest summary of economic projections said median interest rates will go as high as 5.1% in 2023. Do the math, and it implies that the central bank needs to raise rates by 0.75 percentage point from its current policy rate of 4.25% to 4.50%. Participants on the CME FedWatch tool, however, see two 25 basis point rate hikes on Feb. 1 and March 22, respectively, and then a pause.

That’s certainly a bullish scenario. Moving any higher than a quarter point would raise the threat of a recession while inflation, a key rationale for the hike, has already started to cool. Investors are also enthused by the Bank of Canada’s announcement of a pause last week after eight consecutive hikes, something they hope is a prelude to a similar decision by the Fed.

The

S&P 500,
up 6.2% in January, seems to have already priced in the likelihood of easing and a near-term cut, as the gain pushes valuations even higher. “[We] would argue that at 18x forward estimates (which even if soft-landers acknowledge are likely too high), the S&P 500 has seemingly gone ‘all in’ on the soft landing playbook,” writes Michael Darda, chief market strategist at MKM Partners.

It’s not a bet the market should be making. For one, financial conditions are still loose. Take a look at the Chicago Fed’s National Financial Conditions Index. The metric provides a comprehensive weekly update on U.S. financial conditions in money markets, debt, and equity markets since 1971, and its been in the negative territory since May 2020. Fed wants money to be tight, but a negative value indicates financial markets are looser than average.

The labor market tells a similar story. The unemployment rate at 3.5%, matches its half-century low, while the economy showed 10.46 million available positions in November, down just fractionally from October’s total and beating economists’ forecast. Money supply, meanwhile, remains at somewhat historical levels. Currency in circulation, balances in retail money-market funds, savings deposits, and other metrics constituting M2 money supply amounted to $21.2 trillion in December, 37% higher than prepandemic, suggesting more needs to be done.

So while the slowing economy, cooling inflation, and the like may lead to the Fed delivering the expected 25 basis point hike, the least Chairman Powell would have to do is to give a guarded speech to reign in overall market expectation. At the press conference following the Dec. 14 FOMC meeting, he said, “historical experience cautions strongly against prematurely loosening policy,” making it abundantly clear that rates will remain restrictive. There’s a good chance that he’ll make the same point once again.

“Barring a major surprise, Powell’s tone is likely to be much more hawkish than consensus expects,” said Wolfe Research’s Chris Senyek. 

Don’t expect the stock market to like it.

Write to Karishma Vanjani at [email protected]