Investors realizing error in judgment

It’s dawning on stock investors that they were wrong about the Federal Reserve.

After rallying behind a resilient economy, slowing inflation and the hope that the central bank will soon end its interest-rate increases, stock trading has grown jittery.

The benchmark S&P 500 is up just 1% in February, having drifted sideways since it peaked early in the month. Stocks have oscillated between gains and losses as new economic data clouded the outlook for investors, a notable shift in the market after stocks jumped more than 6% in January.

The tone shifted markedly this week as a steady flow of data showed the economy continued to run hot in January. Despite high-profile layoffs at big technology firms like Meta and Microsoft, employers in the United States continued to hire at a rapid clip, consumers kept spending, and prices continued to rise briskly at the start of the year across an array of goods and services.

All those data points suggest that the economy retains significant vigor. The Fed has repeatedly warned that there is more work to do to slow rising prices, even after a year of rapid policy adjustments that were meant to cool down the economy. Now, the continued momentum has undercut some investors’ hopes that inflation will steadily resume the slowdown it began toward the end of last year and allow the central bank to end its rate increases earlier than it had communicated.

In response, investors have sharply raised their expectations for the number of times the Fed will increase interest rates in the coming months. Central bankers have

begun to float the possibility that rates will need to climb higher than they previously expected if the economy does not cool down. Higher interest rates raise costs for consumers and companies, slowing demand and typically weighing on the stock market.

“I’m very negative right now on equities,” said Eric Johnston, the head of equity derivatives at Cantor Fitzgerald, who predicted the recent S&P 500 rally but now expects a slump. “I think the move we have seen in the rate market, some of the inflation numbers that have come out and the expectation that the economy will be fine is all fairly problematic.”

Johnston now thinks the S&P 500 will eventually fall below its 2022 low, a drop of around 15% from current levels. Strategists at Morgan Stanley and JPMorgan Chase are also among those bracing for a fall.

Bond investors had been quicker to shift their view.

At the start of this month, investors betting on the path of interest rates predicted the Fed would raise its benchmark rate just once more this year, by a quarter of a percentage point in March.

Now, those traders are forecasting three increases of that size, through July, which would take the Fed’s target rate to a range of 5.25% to 5.5%. That’s above the Fed’s own most recent forecasts, published in December.

But policymakers have also hinted that their own estimates could be poised for revision if the economy continues to run hotter than previously anticipated.

John Williams, president of the powerful Fed Bank of New York, suggested this week that rates were likely to rise to a range of 5% to 5.5% — slightly above the 5% to 5.25% median in the central bank’s December forecast. He and several of his colleagues have said they expect to lift rates even higher if consumption and the labor market remain so robust.

“With the strength in the labor market, clearly there’s risks that inflation stays higher for longer than expected or that we might need to raise rates higher than that,” Williams told reporters in New York this week.

Loretta Mester, the president of the Fed Bank of Cleveland, said during a speech Thursday that “we may very well have to move higher, hold it longer at that peak rate or even change what we do at any particular meeting” if economic pressures kept inflation elevated.

For investors, that still-aggressive stance rekindled the fear that the Fed’s campaign will push the economy into a downturn. It’s an about-face from the more optimistic view that had taken hold in financial markets at the start of the year, that inflation could fall while the economy continued to grow.

“We had just got comfortable with what the Fed told us it was going to do two weeks ago, and already we are having to rethink that,” said David Donabedian, the chief investment officer of CIBC Private Wealth US, referring to the recent Fed meeting. “The momentum in the market has stopped.”