(Bloomberg Opinion) — Neither war, disease nor inflation are proving capable of keeping U.S. stocks from doing what they have almost always done for 13 years: rising. How policymakers dedicated to controlling inflation will see what is becoming a hot topic on Wall Street.
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Right now, the 6.6% rise in the S&P 500 ranks, in some ways, as the biggest rally to coincide with the start of a Federal Reserve rate-hike cycle since World War II, they show. data compiled by Ned Davis Research and Bloomberg. Buoyed by positive economic reports, stocks just posted their second consecutive week of gains, with the S&P 500 recovering half of its losses since January.
Two different points of view have merged around the demonstration. One, buoyant markets create headaches for central bankers, representing a failing grade in their efforts to curb inflation and work against that goal by keeping financial conditions loose. Another school holds that as long as things remain peaceful in the markets, Fed Chairman Jerome Powell has more leeway to administer the kind of drug needed to get the job done.
“The last thing on Chairman Powell these days is inflation-fighting credibility,” said Michael O’Rourke, chief market strategist at Jonestrading. “Ironically, the more resilient financial markets are, the more opportunities they provide for the president to restore that credibility.”
The S&P 500 has gained in all but two sessions since March 16, when the Fed announced its first rate hike since 2018. On Tuesday, when Powell toughened his stance and said the central bank is prepared to raise rates half a percentage point at its next meeting, the stock gauge rose more than 1%, completing its best six-day rally since 2020.
Along the way, oil prices climbed back above $110 a barrel and segments of the Treasury yield curve inverted, developments that just weeks ago would have sparked recession fears and plunged stocks. There was no such hesitation in evidence this time.
There are many explanations for the resilience of stocks. Sentiment may have faded with professional money managers furiously shedding risk and retail money finally pulling out. At the same time, earnings estimates have risen this year, leading some to speculate that stocks may be working as a hedge against inflation. Others see a market that is simply pleased to see that the Federal Reserve is serious about fighting inflation, arguing that it will bring long-term benefits to the economy.
“In reality, the Fed is just determining the least bad policy to rectify the terrible mistake it made in allowing inflation to soar so high,” said Ipek Ozkardeskaya, a senior analyst at Swissquote. “The good news is that Powell has the wind of the market at his back, for now.”
At a news conference last week, Powell said politics usually works through financial conditions to reach the real economy. That is, higher borrowing costs and lower asset prices would moderate overheated demand, or vice versa.
However, thanks to the rally in stocks, the Bloomberg US financial conditions index has declined even after the Fed’s rate hike. That seems at odds with what central bankers are aiming to achieve.
“Bears worry that rising equities will undermine the Fed’s efforts to tighten broader financial conditions,” said Huw Roberts, chief analyst at Quant Insight. “Under this scenario, rising stocks sow the seeds of their own downfall by prompting a more aggressive Federal Reserve.”
Since the rate hike, economically sensitive stocks such as commodity producers and consumer discretionary have led market gains, a sign that equity investors may be backing Powell’s view that the Fed will be able to engineer a soft landing in the economy.
Bond investors are less optimistic. Inflation expectations have risen as traders bet price pressures will linger beyond 2024, the year in which the current tightening cycle is expected to end. Breakeven inflation rates on five-year and ten-year Treasury bills rose to a record high.
Everything suggests that the Fed would need to hit the brakes harder to cool inflation, which could tip the economy into recession.
A flattering yield curve between 2-year and 10-year Treasuries is one reason Chris Senyek warns against chasing a rally in stocks.
“We are not buying the rebound, given our view that the geopolitical situation remains extremely fluid, inflation should continue to rise and the growth outlook is weakening,” Wolfe Research’s chief investment strategist said.
It remains to be seen whether further weakness in equities could force policymakers to rethink their aggressive stance.
The Fed rarely raises rates when stocks are in danger. The latest rally followed a losing streak in which the S&P 500 fell nearly 10% in three months. Only once since 1990 has there been a rate hike when stocks suffered deeper losses than now, in December 2018. Back then, the Fed changed course seven months later.
But the economic context is different now, with inflation running at 7.9%. In 2018, consumer price gains never exceeded 3%.
“Stronger stocks give the Fed more cover, but I think they will be more responsive to future price increases and labor market performance,” said Kara Murphy, chief investment officer at Kestra Holdings. “So they are willing to sacrifice shares if necessary.”
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