Stock Market Ending February On A Wobbly Note

The stock market is ending February on a decidedly wobbly note, raising doubts about the durability of an early 2023 rally. Blame stronger-than-expected economic data and hotter-than-expected inflation readings that have forced investors to rethink their expectations around how high the Federal Reserve will drive interest rates.

Market Participants Re-Evaluating Fed’s Way of Thinking

Market participants have come around to the Fed’s way of thinking. At the end of January, fed-funds futures reflected expectations that the Fed’s benchmark interest rate would peak below 5% despite the central bank’s forecast for a peak in the 5% to 5.25% range. Moreover, the market was forecasting the Fed would deliver more than one cut by year-end. That view began to shift after the release of the January jobs reports on Feb. 3 that showed the U.S. economy added a much larger-than-expected 517,000 jobs and showed a drop in the unemployment rate to 3.4% — its lowest since 1969. Throw in hotter-than-expected January consumer and producer price index readings and Friday’s bounce in the core personal consumption expenditures price index, the Fed’s favored inflation measure, and the market’s outlook on rates looks much different.

Participants now see the Fed raising rates above 5% and holding them there through year-end. The question is whether the Fed will bump up its forecast of where it expects rates to peak at its next policy meeting in March.

Backup in Treasury Yields and Pullback By Stocks

That’s translated into a backup in Treasury yields and a pullback by stocks, with the S&P 500 down around 5% from its 2023 high set on Feb. 2, leaving it up 3.4% in the year to date through Friday.

It isn’t just that investors are learning to live with the Fed’s expectation for rates; it’s that investors realize that bringing down inflation will be a “bumpy” process, said Michael Arone, chief investment strategist for the SPDR business at State Street Global Advisors, in a phone interview. After all, he noted, it took former Fed Chairman Paul Volcker two recessions in the early 1980s to finally crush a bout of runaway inflation.

Run to the S&P 500’s Feb. 2 High Led By “Dash For Trash”

The run to the S&P 500’s Feb. 2 high was led by what some analysts derisively called a “dash for trash.” Last year’s biggest losers, including highly speculative shares of companies with no earnings, were among the leaders on the way back up. Those stocks suffered particularly last year as the Fed’s aggressive cadence of rate hikes sent Treasury yields up sharply. Higher bond yields make it harder to justify holding stocks whose valuations are based on earnings and cash flow projected far into the future.

Inflation Readings This Month Hotter Than Expected

Inflation readings this month have all been hotter than expected, resulting in the “reversal of everything that was working” previously, Arone noted. He said that the 10-year Treasury yield had fallen, and the dollar was weakening, which means that highly speculative, volatile stocks are giving back leadership to companies that benefit from rising rates and inflation. The energy sector was the sole winner among the S&P 500’s 11 sectors in the past week, while materials and consumer staples outperformed.

Related Facts

• The S&P 500 was up 3.4% throughout the year through Friday.
• The 10-year Treasury yield had fallen.
• The dollar was weakening.

Key Takeaways

• Stronger-than-expected economic data and hotter-than-expected inflation readings have caused investors to rethink their expectations about how high the Federal Reserve will drive interest rates.
• The market is now forecasting the Fed will raise rates above 5% and hold them there through at least year-end.
• This month’s inflation reading save resulted in the “reversal of everything that was working” previously.

Conclusion

The stock market is ending February on a shaky note as investors re-evaluate the Federal Reserve’s way of thinking and inflation readings that have been hotter than expected. This has resulted in a backup in Treasury yields and a pullback by stocks, with the S&P 500 down around 5% from its 2023 high set on Feb. 2. With the Fed expected to raise rates above 5%, investors are learning to live with the Fed’s expectation for rates, and realizing that bringing down inflation will be a “bumpy” process.