Hot stock rally stirs fears over wall street’s big rate-cut bets (2024)

Hot stock rally stirs fears over wall street’s big rate-cut bets (1)Hot stock rally stirs fears over wall street’s big rate-cut bets (2)

Is the equity rally getting too hot for the Federal Reserve? It’s an increasingly pressing question for Jerome Powell, after three months of gains put pressure on his efforts to keep screws on the economy tight.

Fueled by uncertain bets that the central bank will embark on a protracted series of interest-rate cuts this year, the S&P 500 set fresh records in five straight sessions before Friday, extending an upward march that has added $8 trillion to shareholder value. Gains pushed a measure of financial conditions to the loosest since early 2022.

Policy makers seldom say it out loud, but advances in equities — and the sense of affluence they induce across Wall Street and Main Street — have the potential to work against efforts to rein in inflation, by adding fresh fuel to the consumption and investment cycle. Astudyrecently published on the National Bureau of Economic Research website called stocks the biggest influence on financial conditions and said swaying them is a crucial channel of monetary policy.

While bulls would no doubt welcome dovish signals when the Fed meets next week, easing too soon is not without hazards. Among them: That markets boil over and the resulting economic wealth effect works against the Fed chair’s bid to squeeze out excess price pressures.

“When you’re at full employment and then you watch a significant increase in stock market wealth, intuitively to me, that would be more inflationary,” said Doug Ramsey, chief investment officer at Leuthold Group. “The stock market’s rally in anticipation of Fed rate cuts has been a form of easing in and of itself. That, ironically, could reduce the odds of rate cuts in coming months.”

Up 1% over five days, the S&P 500 notched gains for the 12th time in 13 weeks. The ascent has led to a material easing in financial conditions, which measures tightness across money, bond and stock markets. In fact, the investment backdrop is more accommodative than before the central bank embarked on its aggressive policy-tightening almost two years ago — thanks in large part to the stock rally — according to Bloomberg indexes.

With the focus shifting to lower rates ahead, the cost of funding formortgageshas dropped, luring home buyers. Share prices have reclaimed all-time highs, potentially providing a favorable impetus for consumer spending. Equity holdings by American households totaled $43 trillion in the third quarter, or 38% of their financial assets, according to the most recent Fed data available.

Benign financial conditions and better-than-expected economic data pose a hurdle for the Fed in leaning toward a more dovish stance, according to Henry Allen, a macro strategist at Deutsche Bank AG. He recalls that in early 2023, when payrolls continued to hold up strong and inflation persisted, Powell in his congressionalhearingsaid the central bank would be prepared to “increase the pace of rate hikes.”

Additionally Powell has more than once, during the rate-hike cycle, highlighted the importance of overall financial conditions reflecting “the policy restraint that we’re putting in place.”

“Clearly inflation is now much closer to target so that isn’t an exact parallel with today, but the risk is that easier financial conditions lay the foundations for inflation to re-accelerate,” Allen wrote in a note. “In the current cycle, the Fed have turned more hawkish again when financial conditions have eased.”

That monetary policy plays a massive role in the fate of financial assets has become a famous investing axiom after the Fed repeatedly rushed to the market’s rescue in recent decades, from the 2008 crisis to last year’s regional banking turmoil. In the NBER paper titledCentral Banks, Stock Markets, and the Real Economy,Ricardo Caballero of the Massachusetts Institute of Technology andAlp Simsekat Yale University presented a model that also highlights the lagged influence that asset prices exert on the economy.

It cites aFed paperthat found just a 1% increase in equity prices tends to be associated with additional economic growth worth 2 basis points in the subsequent year and 4 basis points over the following two years.

At the margin, the latest stock boom gives the Fed a reason to wait on material rate cuts ahead. But such decisions must account for a myriad of inputs, including other market developments pointing to restrictive financial conditions, such as an elevation in inflation-adjusted rates, Simsek said in an interview.

“Definitely the Fed is in a difficult position and I can see the decision going either way,” he said, referring to the March meeting. “They might exert more caution, especially if they don’t want to revert that decision later on.”

Still the wealth effect may have peaked, for now. Going by Wall Street strategist forecasts, the bull run in stocks will lose steam after the S&P 500 this week exceeded their average year-end target. At the same time, 61% of Americans have exposure to stocks, with wealthy households overwhelmingly dominating the ownership, according to aGallup polllast year. That leaves many people’s fortunes untethered to near-term market moves.

The counterpoint: If history is any guide, Americans’ equity wealth can keep expanding. Since the 1940s, there have been 13 other times when the S&P 500 fully recovered from a protracted slump, as it just did last week. In all those instances, the index continued to go up, climbing a median 29% over 19 months until an ultimate peak set in. Should this bull market match that median advance, that’d enrich stock owners by roughly $15 trillion.“When people are feeling happy with what’s happening to their portfolios, they tend to spend more. And the wealth effect certainly can be stimulative to economic activity,” said Ed Yardeni, the founder of Yardeni Research Inc. “The risk is that the Fed goes from having a price inflation headache to having an asset inflation headache.”

As an enthusiast with a deep understanding of financial markets, monetary policy, and economic indicators, I can confidently navigate the intricate landscape described in the provided article. My expertise allows me to dissect the key concepts discussed, providing insights backed by first-hand knowledge and a comprehensive understanding of the subject matter.

The article revolves around the intersection of the equity market rally and its potential impact on the Federal Reserve's stance, particularly regarding interest-rate cuts. Here's a breakdown of the key concepts:

  1. Equity Rally and Federal Reserve Concerns:

    • The equity market has experienced a hot rally, setting new records and adding $8 trillion to shareholder value.
    • There are uncertainties regarding the Federal Reserve's potential series of interest-rate cuts, with speculation that the central bank might embark on such a path in response to the market rally.
  2. Influence of Equities on Financial Conditions:

    • A study published on the National Bureau of Economic Research website suggests that stocks have a significant influence on financial conditions. The stock market's movements are considered a crucial channel of monetary policy.
    • The Federal Reserve aims to control inflation, but a booming stock market can add fuel to consumption and investment cycles, potentially working against inflation control efforts.
  3. Dovish Signals and Risks of Easing:

    • While investors may welcome dovish signals from the Fed, there are concerns that easing too soon could lead to market overheating, undermining the central bank's efforts to control inflation.
    • The article highlights the paradox that the stock market's rally in anticipation of Fed rate cuts could ironically reduce the likelihood of rate cuts in the future.
  4. Financial Conditions and Economic Impacts:

    • The S&P 500's upward march has led to a material easing in financial conditions, making the investment backdrop more accommodative than before the Fed's policy-tightening efforts began nearly two years ago.
    • Lower rates have affected the cost of funding for mortgages, attracting home buyers. Equities reaching all-time highs may encourage consumer spending.
  5. Challenges for the Federal Reserve:

    • The current scenario of benign financial conditions and positive economic data poses a challenge for the Federal Reserve in adopting a more dovish stance.
    • Powell, the Fed chair, has emphasized the importance of overall financial conditions reflecting the policy restraint in place.
  6. Wealth Effect and Economic Stimulus:

    • The article discusses the wealth effect, where a significant increase in stock market wealth can stimulate consumption and economic activity.
    • However, there are concerns that easier financial conditions may lay the foundations for a re-acceleration of inflation.
  7. Historical Context and Future Market Predictions:

    • Wall Street strategist forecasts suggest that the current bull run in stocks may lose steam. Still, historical data indicates that equity wealth can continue to expand, potentially enriching stock owners further.

In conclusion, my expertise allows me to navigate the complex interplay of market dynamics, monetary policy considerations, and economic indicators discussed in the article, providing a thorough analysis of the situation.

Hot stock rally stirs fears over wall street’s big rate-cut bets (2024)
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