Stocks started with a bang thanks to strong corporate earnings reports, but ended with a thud thanks to hawkish comments from President Powell during a panel at the IMF. Interest rates have risen short and the long end of the curve, with the 10-year Treasury yield climbing to 2.9% and the 2-year yield hitting a new high of 2.68%. Yet Chairman Powell’s assertion that we will see a 50 basis point rate hike at the next Fed meeting in May is nothing new. Fed funds futures already had the probability at 93.8%.
What has changed is the likelihood of rate increases of 50 basis points or more at each of the next three meetings in May, June and July. The probability of a 2% fed funds rate over this period has fallen from 37.9% the day before Powell’s comments to 62.9% after, which is why 2-year yields hit a new high of 2.68% and stocks headed south. I think the market is extrapolating the tightening from Powell’s comments way too much.
Provided the inflation rate peaks before the July meeting, if it hasn’t already happened, the Fed is highly unlikely to raise rates by 50 to 75 basis points at this month’s meeting. -the. Year-to-year price comparisons between now and then will become more difficult for several components of the Consumer Price Index. Consider that WTI crude was in the mid-$70s last July compared to the mid-$60s last April, and we’ve already seen oil well past its March high of $130. Gasoline prices are expected to follow, as are new and used car prices.
What I find encouraging is that despite the continued rise in both short-term and long-term rates, which anticipate increasingly tight financial conditions, the S&P 500 continues to rise from its February low. Indeed, corporate earnings are well above expectations and higher bond yields are not high enough to create a more attractive inflation hedge for equities.
Aggressive bond market moves to tighten ahead of Fed policy decisions set the stage for a loosening of those expectations in the months ahead. I think this will be the fuel that will help the major market averages recoup their year-to-date losses. The first signs of easing would be to see the 2-year yield start to pull back from its recent peak. The first sign of an inflation peak would be a capping of the 10-year rate at 3%. That’s my expectation by July. At the same time, if corporate earnings can continue to grow sequentially throughout the year, we should recoup this year’s losses within major market averages.
I am not blind to the possibility that long-term rates could climb well above 3% this year. It took a 3.25% rate in the fourth quarter of 2018 to create a significant headwind for equities, but the inflation rate was below 2% and real yields were in positive territory. I think the threshold is closer to 3.5-4% today, but we will have to listen to the market for clues if we cross 3.25%.
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