Broker Check

The Market Is Beginning to Believe the Fed

June 27, 2023

News flow was centered on central bank decisions and the future outlook for policy rates in the months ahead with consideration of the latest economic developments. In short, hawkish central bank commentary and actions over the past two weeks have increased market fears that high rates will ultimately cause a real, meaningful slowdown in economic growth, and that’s counter to the “Immaculate Disinflation” hope that pushed stocks higher in early to mid-June (“Immaculate Disinfla- tion” assumes falling inflation and stable growth, not falling inflation and slowing growth).

After the June Fed decision including the release of the FOMC’s economic and policy forecasts, investors widely anticipated that “pause” or “skip” decision would mark the end of the rate hiking cycle as inflation was seen as dropping rapidly while growth remained resilient. That left optimistic hopes of a soft landing intact and the “Growth On” trade that had begun to outperform at the start of June ex- tended gains. But that dynamic began to change almost immediately with the ECB’s hawkish tone in the wake of the Fed as more rate hikes were all but guaranteed by Lagarde. Then last week, U.K. CPI came in hot and the BOE raised rates by more than expected with terminal rates moving meaningfully higher while Powell maintained a hawkish tone and effectively said that a unified Fed continues to anticipate more rate hikes between now and year end in their committed fight against inflation.

The market reaction to this string of developments showed that investors began to respect the Fed fore- casts and price in more rate hikes based on the price action in fed funds futures and short-duration yields. At the same time, recession fears rose, underscored by a pullback in longer-duration yields last week. If that continues, the cyclical sectors will lag (they’ve outperformed this month) and defensive sectors come back in favor (they’ve lagged all year).

Although this remains our defensive approach, we are researching how we can start easing into large cap growth. More on that in the next week.
Bottom line, momentum in stocks remains higher and last week’s pullback needs to be viewed primarily as digestion/consolidation of the intense rally of April-June. But, the single biggest threat to this rally is an economic slowdown, so while last week’s data wasn’t conclusive, we will continue to monitor the data because if it points towards a slowing economy, then that does have the power to erase the suddenly widespread optimism towards stocks, and cause a meaningful pullback (and with sentiment this bullish, that can happen quickly).

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