Strong Economic Data Weaken the Case for Continued Stock Rally

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The dash for trash has hit a speed bump. Stocks faltered again this past week as the early-year rally, led by rebounds in 2022’s speculative-grade losers, ran into resistance from higher expected interest rates from the Federal Reserve in the wake of persistent inflation readings and few signs that growth is faltering.

Economists at an array of major Wall Street banks, including Goldman Sachs, Bank of America, and Citigroup, lifted their forecasts of the eventual peak in the central bank’s target range for the overnight federal-funds rate, to 5.25% to 5.50%, effectively bringing them in line with the fed-funds futures market. Deutsche Bank now is expecting a 5.6% single-point peak, up a half-percentage-point from its previous estimate, and among the highest forecasts.

According the CME Group’s FedWatch site, the futures market is pricing in three more quarter-point hikes, from the current 4.50% to 4.75%, at the Federal Open Market Committee’s March, May, and June meetings. The change in outlook was the addition of the last quarter-point move, with a 57.5% probability of a peak of at least 5.25% to 5.50% in June, as of Friday’s settlement. That’s up from under 41.8% a week ago and less than 4% a month earlier.

The shift in these odds reflects a recent string of economic data showing higher-than-forecast gains in employment and retail sales for January, along with less easing in inflation at the consumer and producer levels.

Two Fed district presidents, Loretta Mester of Cleveland and James Bullard of St. Louis, also opined this past week that here had been a good case for a half-point rate hike at the last FOMC meeting, instead of the quarter-point move. That confab concluded on Feb. 1, before those hotter-than-expected economic releases arrived. Neither of these policy hawks are voters in this year’s rotation, however. But the panel will lose a prominent dove with the departure of Lael Brainard, the Fed Board’s vice chair, to head the White House’s National Economic Council.

Prominent among the data was January’s consumer price index, which was up by a greater-than-expected 0.5%, bringing the year-over-year increase to 6.4%. More important, the recent shorter-term slowing in retail price rises has halted, notes Matthew Luzzetti, Deutsche Bank’s chief U.S. economist; the annualized rise in the latest three months was 4.6%, up from 4.4% in December. The moderation in the pandemic run-up in prices of core goods appears to have run its course. As Dallas Fed President Lorie Logan pithily observed in a speech this past week, “Supply chains can’t recover twice.”

Much of the early-year rally also had been driven by a largely unrecognized global liquidity surge noted by Citi global markets strategist Matt King. Even as the Fed was reducing its balance sheet (aka quantitative tightening), actions by the European Central Bank, the Bank of Japan, and the People’s Bank of China were adding $1 trillion to global liquidity, he writes in a provocative research note. At the same time, the impact on bank reserves of the Fed’s cut in its securities portfolio largely has been offset by changes in the Treasury account at the Fed and so-called reverse repurchase agreements (which were discussed at length here several weeks ago).

However, King writes, most of this boost is past. From here on, liquidity appears to be drained; that probably will hurt risk assets, including stocks.

This past week, the major averages ended mixed, but off their 2022 highs touched on Feb. 2. That was the day after the last FOMC meeting, which encouraged hopes that the Fed’s rate hikes were close to an end. It also was the day before the news of the blowout 517,000 surge in January’s payrolls suggested otherwise.

On the week, the

S&P 500
slipped 0.28%, its second straight weekly decline. The big-cap benchmark closed on Friday up 6.24% since the turn of the year, but off 2.41% from its peak at the beginning of the month.

Further rises in short-term interest rates are likely to be a hurdle for stocks and other risky assets, as long as inflation remains stubborn.

Write to Randall W. Forsyth at [email protected]