Wednesday saw a surprising turn of events in financial markets as Federal Reserve Chair Jerome Powell indicated that a March interest-rate cut was unlikely. This led investors to anticipate a potential “policy mistake” by the central bank.
The impact of Powell’s comments was evident as U.S. stocks experienced a sell-off, with equity indexes reaching their lowest levels of the session. The S&P 500 ultimately recorded its worst day since September.
Simultaneously, Treasury yields fell, resulting in a rally in bonds. Fed-funds-futures markets even priced in the possibility of up to six cuts later in the year, with the first one expected in May, according to the CME Group’s FedWatch tool.
The market response, characterized by stock sell-offs and bond rallies, caused concern within Wall Street. This pattern used to be seen as a classic “risk off” trade, but since the Fed began raising interest rates in March 2022, stocks and bonds have moved synchronously. As yields rose, stocks fell, and vice versa.
Market strategists interpreted this market reaction as a clear signal of investor apprehension that the Fed may not act quickly enough to cut interest rates and avert an economic downturn in the U.S. This uncertainty has undermined the hopes of achieving a “soft landing,” which had been driving the upward momentum of U.S. stocks in recent months.
Nicholas Colas, co-founder of DataTrek Research, underscored the market’s growing anticipation of a Fed policy mistake, stating, “Markets are starting to discount a Fed policy mistake.” Similarly, Charlie McElligott, a derivatives market strategist at Nomura, regarded Powell’s decision to downplay the chances of a March cut as a “mistake,” asserting that market reactions would likely be unfavorable if inflation continues to decline before the Fed’s March meeting.
In the past, the Fed faced criticism for hesitating to raise interest rates until March 2022, despite expectations of transitory inflation. This time, a policy mistake would involve the central bank leaving interest rates too high for an extended period of time.
Examining the Risks of the Fed’s Decision
As Mohamed El-Erian, chief economic adviser at Allianz, recently analyzed in a post, the Federal Reserve’s choice to delay a cut in interest rates is raising concerns about potential risks. Powell’s decision has sparked debates among economists regarding the possibility of the Fed being late once again, but this time in the opposite direction.
The Significance of the Real Rate of Interest
With the easing of inflation, the real rate of interest, calculated by deducting the current inflation rate from the nominal rate set by the Fed, is on the rise. Many economists argue that this real rate plays a crucial role in impacting economic growth. When interest rates surpass the economy’s neutral rate of interest for extended periods, it poses a significant threat to growth.
However, determining the exact neutral rate of interest, commonly known as “r*”, remains a challenging task for both the Fed and economists. During a recent press conference, Powell emphasized that the Fed doesn’t possess concrete knowledge about this neutral rate.
Debating Market Expectations
Despite concerns about a potential policy error by the Fed, some strategists have a different perspective. Jeffrey deGraaf, a technical strategist at Renaissance Macro Research, discussed in a client note that corporate credit spreads remained relatively stable, contradicting the notion that investors are preparing for an economic downturn.
According to deGraaf, as long as corporate credit conditions do not deteriorate, a decline in nominal and real yields can still be seen as favorable.
Market Recovery and Falling Yields
Following the recent downturn in the S&P 500, there is now a resurgence in U.S. stocks early on Thursday. The S&P 500, Dow Jones Industrial Average (DJIA), and Nasdaq Composite (COMP) are all trading higher. At the same time, the yield on the 10-year note (BX:TMUBMUSD10Y) continues to decrease, currently down 7 basis points at 3.89%.
In conclusion, the Fed’s decision presents both potential risks and differing viewpoints among economists and strategists. The market reaction and corporate credit conditions will be key indicators to watch in the coming days.