The market’s decision to switch to a more forgiving Fed may have been a grave error. Several Fed governors and board members have stated publicly this week that rates will still need to rise significantly and remain there for some time in order to bring inflation back to their 2% target.
The Fed Funds Futures were the first to respond to that message, which appears to be spreading throughout the markets. The biggest change seems to have happened just last week, right before the Fed’s initial rate cut.
The Fed Fund Futures were pricing in the first rate decrease in March 2023 last week, but that date has since been moved to May 2023. The Fed Funds Futures also experienced a top rate of 3.25%; rates are currently anticipated to peak at 3.45%. If the Fed gets its way, rate cuts will be delayed even further and interest rate expectations would rise.
The market had convinced itself after the FOMC meeting that a data-dependent Fed would result in a more dovish, stock market-friendly Fed, so even while it may be a minor movement, it is a shift nonetheless. The Fed may need to raise rates much higher and maintain them high for longer than anticipated, according to the Fed governors’ tone since the meeting.
Due to the erroneous perception of the market, recent gains in stocks, particularly growth-oriented firms, have been driven by easing financial conditions and declining real yields. Real yields should climb as financial conditions start to tighten again as the market reprices for a Fed that isn’t expected to be done hiking rates anytime soon.
QQQ And TIP Daily In times of tighter financial conditions, margin levels would be reduced, while increasing real yields would act to bring down the PE ratio and stock valuations. The QQQ ETF and the TIP ETF have a strong correlation, with the latter indicating higher real rates when the former is declining. The QQQ ETF has a history of doing so, so if the TIP starts to trend lower once more, it would seem that eventually the QQQ should do the same.
As long as the Fed keeps sending hawkish signals, the current rate reduction and easing of financial conditions are unlikely to sustain. Additionally, the Fed requires financial conditions to tighten, not ease, in order to reduce inflation. When a result, as circumstances loosen, the Fed is working against that goal, making the current surge seem ludicrous on a number of different levels. Rising share markets alleviate banking conditions but eventually making the Fed’s task more difficult. In the long run, it might even mean that the Fed needs to raise rates even further.
So yes, equities can rise farther, but at their own risk.
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