The Federal Reserve has been warning markets for months that inflation will take time to tame, and rates will need to rise higher in order to do it, thanks in part to a resilient job market, confident consumers and a surprisingly robust economy.
Bond investors, long reluctant to believe anyone but themselves, have fought against that narrative for most of the past year, either by betting that the Fed won't be able to lift rates as high as they'd like without tipping the economy into recession or, more recently, placing wagers on rate cuts in anticipation of a policy error from Chairman Jerome Powell.
That's not happening now.
DON'T MISS: Inflation Steady in January, Complicating Fed Battle
Wednesday's blowout January retail sales report, which showed overall spending up 3% from the previous month to a collective $697 billion, set against faster-than-expected inflation and a forecast-busting jobs report, has forced a wholesale reset in the bond markets.
"Consumer spending bounced back in early 2023, adding to evidence from the blockbuster jobs report that the economy kicked off the year stronger than expected," said Bill Adams, chief economist for Comerica Bank in Dallas.
"Household surveys show consumers are getting a little more concerned about recession risks, but they are still spending—and with consumer spending accounting for about 70% of GDP, it is hard for the economy to enter recession as long as consumer spending is growing," he added.
Benchmark 2-year Treasury note yields rose to 4.634% Wednesday, marking a near 53 basis point surge since the start of the month and the highest since early November.
Benchmark 10-year Treasury notes, meanwhile, have risen past the 3.81% level -- on pace for the highest close of the year with increasing calls for move towards 4% -- as investors abandon calls for a rate cut and heed the Fed's signaling on near-term rate hikes.
'Right Kind of Framing' for Rate Policy: NY Fed Chief
The CME Group's FedWatch, in fact, is pricing in a 47.3% chance of a 25 basis point rate hike in June, following on from similar increases in March and May, marking the first real bets on a Fed Funds rate that would approach 5.5%.
That level, in fact, "seems to be the right kind of framing" for interest rate policy, New York Fed President John Williams said Tuesday following a speech to the New York Bankers Association.
"With the strength in the labor market, clearly there are risks that inflation stays higher for longer than expected, or that we might need to raise rates higher," he said, echoing views expressed by Richmond Fed President Thomas Barkin, who told Bloomberg TV that while inflation is "normalizing ... it's coming down slowly. I just think there's going be a lot more inertia, a lot more persistence to inflation than maybe we'd all want."
Stock markets, however, aren't heeding the message, or at least aren't as concerned that the Fed can engineer a so-called 'soft landing' for the world's biggest economy.
The S&P 500 is up around 7.8% for the year, with modest gains in February, and has powered more than 18% higher since its early October nadir, even amid tumbling profit forecasts, big tech job cuts and an uncertain outlook for the global economy.
"The CPI report, coupled with January’s strong jobs numbers, will reinforce a 'tighter for longer' narrative for the Fed," said BMO Wealth Management's chief investment strategist Yung-Yu Ma. "For the equity markets, this points to a path of choppiness as the sharp gains to begin the year need to be digested as additional data arrives in the coming weeks and months."
"The markets want the economy to 'walk the line' of moderating growth and cooling inflation that leads to a soft landing and a benign Fed rate path," he added.
Corporate Profits Are Lagging
But while the economy looks increasingly likely to avoid recession -- the Atlanta Fed's GDPNow forecasting tool currently pegs the pace of U.S. economic growth at around 2.2% -- the same can't be said for corporate profits. And that may challenge the idea that stocks will 'thread the needle' by ducking faster inflation while growing their earnings potential.
With around 70% of the S&P 500 reporting fourth quarter earnings, collective profits are expected to fall 2.8% from 2021 levels to around $443 billion. Stripping out the energy sector takes that decline to around 7.1%.
For the first three months of this year, profits are likely to fall by 3.7%, to around $427.5 billion, marking the first so-called earnings recession since the Covid-hit era of 2020.
So, what's going on here?
Stock markets, traditionally, are good indicators of where the economy will be in 18 months time, rather than what it's doing today.
LPL Financial's Jeffrey Buchbinder and Jeffrey Roach, the group's chief equity strategist and chief economist respectively, suggest that indication is perhaps more positive than it appears.
Higher rates challenge stock performance as an investment alternative, and slumping profits boost the level of price/earnings ratios that make equities seem more expensive. But big investors are taking on riskier stocks -- many of which powered the January rally -- and while the Fed remains hawkish, it's coming to the end of its rate hike cycle fairly soon.
"While we acknowledge downside risk to earnings in a recession scenario, the risk to valuations from further increases in interest rates, and the market’s increasing optimism based on where the biggest 2023 gains are so far, we expect the October lows to hold and see solid, double-digit gains for stocks in 2023," the pair wrote.
"Bears seem smart but bulls make you money" is an often-heard adage on Wall Street. Right now, stocks are appealing to anyone with a sense of optimism, while bonds offer downside protection and the comfort of capital preservation.
