Federal Reserve Chair Jerome Powell sent a clear signal that interest rates are rising and will stay there for longer than previously expected. Investors are wondering if this means the battered stock market is about to make new lows.
“If we don’t see inflation falling as the fed funds rate rises, then we’re not getting to the point where the market can see the light at the end of the tunnel and start making a turn,” said Victoria Fernandez, chief market strategist at Crossmark Global Investments. “Typically, you don’t bottom out in a bear market until the fed funds rate is higher than the inflation rate.”
US stocks initially rallied after the US Federal Reserve approved a fourth straight hike of 75 basis points on Wednesday, bringing interest rates to a range between 3.75% and 4%, with a statement that investors took as a signal that that the central bank would deliver fewer rate hikes in the future. However, a more hawkish-than-expected Powell threw cold water on the half-hour market party, sending stocks plummeting and sending Treasury yields and fed funds futures higher.
See: What’s next for markets after the Fed’s 4th jumbo rate hike in a row
In a news conference, Powell stressed that it was “very premature” to consider pausing interest rate hikes and said the final level of the Federal Funds Rate would likely be higher than policymakers had anticipated in September.
According to the CME FedWatch tool, the market is now pricing in over a 66% chance of a rate hike of just half a percentage point at the Fed’s Dec. 14 meeting. The key rate would thus remain in a range of 4.25% to 4.5%.
But the bigger question is how high interest rates will ultimately go. In the September forecast, Fed officials had put a median of 4.6%, which would suggest a range of 4.5% to 4.75%, but economists are now expecting a final rate of 5% through mid-2023.
Read: 5 Things We Learned From Jerome Powell’s Whipsaw Press Conference
For the first time ever, the Fed also acknowledged that the cumulative monetary tightening could ultimately hurt the economy with a “lag”.
According to strategists, it typically takes six to 18 months for rate hikes to come through. The central bank announced its first quarterly basis point hike in March, meaning the economy should start feeling some of the full impact of that by the end of this year, and won’t feel the maximum impact of this week’s fourth 75 basis point hike through August 2023
“The Fed would have liked to see a bigger impact from the tightening by Q3 of this year on financial conditions and the real economy, but I don’t think they’re seeing enough impact,” said Sonia Meskin, head of US macro at BNY Mellon Investment Management . “But they also don’t want to accidentally kill the economy…which is why I think they’re slowing the pace.”
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Mace McCain, chief investment officer at Frost Investment Advisors, said the main goal is to wait until the maximum impact of rate hikes is transmitted to the job market, as higher interest rates push house prices higher, followed by more inventory and less construction, which is a less resilient labor market.
However, government data show that the US economy added a surprisingly strong 261,000 jobs in October on Friday, beating a Dow Jones estimate of 205,000 new jobs. Perhaps more encouraging for the Fed is the unemployment rate, which rose to 3.7% from 3.5%.
US stocks ended sharply higher in a volatile trading session on Friday as investors assessed what a mixed jobs report means for future Fed rate hikes. But major indices posted weekly declines, with the S&P 500 SPX down +1.36% down 3.4%, the Dow Jones Industrial Average DJIA up +1.26% down 1.4% and the Nasdaq Composite COMP up +1 .28% declined by 5.7%.
Some analysts and Fed watchers have argued that policymakers would prefer stocks to remain weak as part of their effort to further tighten funding conditions. Investors may wonder how much wealth destruction the Fed would tolerate in order to crush demand and quell inflation.
“It’s still open for discussion because with the cushion of stimulus components and the cushion of higher wages that many people have been able to earn in recent years, demand destruction is not going to happen as easily as it would have in the past,” Fernandez told MarketWatch on Thursday. “Obviously they (the Fed) don’t want to see a total collapse in stock markets, but like in the press conference [Wednesday], that’s not what you see. I think they are okay with a little asset destruction.”
Related: Here’s why the Federal Reserve pushed inflation to a 40-year high and how it rattled the stock market this week
BNY Mellon Investment Management’s Meskin feared there was little chance the economy could achieve a successful “soft landing” — a term used by economists to describe an economic slowdown that could tip into a recession avoids.
“As they (the Fed) get closer to their own estimated neutral rates, they try to calibrate subsequent hikes to gauge the impact of each hike as we move into restricted territory,” Meskin said over the phone. The neutral interest rate is the level at which the Fed Funds rate neither stimulates nor slows down economic activity.
“So they say they will start raising interest rates by smaller amounts sooner rather than later. But they also don’t want the market to react in a way that would loosen financial conditions because any loosening of financial conditions would be inflationary.”
Powell said on Wednesday there is a chance the economy may emerge from a recession, but that window for a soft landing has narrowed this year as price pressures have been slow to ease.
However, Wall Street investors and strategists are divided on whether the stock market has fully priced in a recession, especially given relatively strong third-quarter results from more than 85% of S&P 500 companies reporting and forward-looking earnings expectations .
“I still think that when we look at earnings expectations and market prices, we’re not really pricing in a significant recession yet,” Meskin said. “Investors still give a pretty high probability of a soft landing,” but the risk from “very high inflation and the Fed’s own estimates that the terminal rate is rising is that we end up with much higher unemployment, and therefore a lot Must have lower ratings.””
Sheraz Mian, research director at Zacks Investment Research, said margins are holding up better than most investors expected. For the 429 constituents of the S&P 500 index that have already reported results, total earnings are up 2.2% from the year-ago period, with 70.9% beating EPS estimates and 67.8% beating sales estimates, Mian wrote on Friday in an article.
And then there’s the midterm congressional elections on November 8th.
Investors debate whether stocks can gain ground after a hard-fought battle for control of Congress, as historical precedent suggests stocks tend to rise after voters go to the polls.
See: What midterms mean for the stock market’s “best 6 months” as the favorable calendar stretch begins
Anthony Saglimbene, chief market strategist at Ameriprise Financial, said equity volatility typically spikes in markets 20 to 25 days before an election and then falls in the 10 to 15 days after the results are announced.
“We actually saw that this year. If you look at mid to late August where we are right now, volatility has been up and kind of starting to go down,” Saglimbene said Thursday.
“I think one of the things that has allowed the markets to push back the midterm elections is that the likelihood of a split government is increasing. In terms of market reaction, we really think the market could react more aggressively to anything outside of a divided government,” he said.