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Stock, Bond and Crypto Investors Bet Fed Is Bluffing on Interest Rates

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The market’s big comeback in January is indicative of one thing: Investors don’t believe the Federal Reserve is going to keep interest rates high for long.

Stock and bond prices have jumped to start the year. Particularly risky assets have run up even faster.

An index of nonprofitable technology companies compiled by Goldman Sachs is up 28% after sinking in 2022, while the bank’s index of the most-shorted stocks in the Russell 3000 Index has climbed 23% following its worst year on record. Even bitcoin has risen. The cryptocurrency has surged 43% this year despite industry layoffs, regulatory scrutiny and the bankruptcy of the lender Genesis Global Holdco LLC.

In comparison, the S&P 500 is up 7.3%, including a 1% jump Wednesday, when the central bank raised interest rates at a slower pace than it did in December but signaled its fight against inflation wasn’t done.

Many investors are skeptical that the Fed will keep interest rates higher for longer, despite the central bank’s outlook that it is unlikely to cut rates at all this year. They think last year’s rate increases will sharply slow the economy and lead the Fed to cut rates as joblessness climbs. Others see economic nirvana, in which inflation falls rapidly without a serious downturn, allowing the Fed to ease.

“The markets are calling their bluff,” said Johan Grahn, head of exchange-traded funds at Allianz Investment Management.

Fed Chair

Jerome Powell

didn’t try to push back against market expectations of a shallower rate path during Wednesday’s press conference and instead chalked up the divergence to a “difference in perspective…on how fast inflation will come down.”

He added, “I’m not going to try to persuade people to have a different forecast, but our forecast is that it will take some time and some patience, and that we’ll need to keep rates higher for longer.”

Fed officials have said they are also setting expectations for a slightly firmer rate path because when they weigh the risks of different policy decisions, they seek to avoid taking actions that are the most costly to correct if they are wrong.

Projecting a slightly higher rate trajectory shows officials are prepared to take out insurance against a scenario in which the economy faces new shocks that drive inflation higher. Markets don’t have to worry about that risk.

“It’s our job to restore price stability and achieve 2% inflation,” said Mr. Powell, who spent most of his career in finance. “Market participants have a very different job. It’s a fine job. It’s a great job. In fact, I did that job for years, in one form or another. But we have to deliver.”

From the perspective of a central banker such as Mr. Powell, “The greatest danger is to allow inflation to spiral upwards,” said Daleep Singh, a former senior executive at the Federal Reserve Bank of New York who is now chief global economist at PGIM Fixed Income. “For market participants, the risk is that you’re missing out on a market rebound.”

A situation in which the market has an outlook different from the Fed’s isn’t necessarily a problem for the central bank in the longer run.

“You can learn from what the market is thinking and saying,” said William English, a former senior Fed economist who is a professor at Yale School of Management. “That’s information for policy makers. It isn’t something to be particularly feared.”

Federal Reserve Chair Jerome Powell said more rate increases will likely be needed to continue lowering inflation. Photo: Kevin Dietsch/Getty Images

On the other hand, if investors are anticipating a faster turn to rate cuts because they don’t understand or believe that the Fed is committed to holding rates higher for longer, that could force the Fed to raise rates more than it otherwise would.

A measure of financial conditions from the Federal Reserve Bank of Chicago has continued to fall since October. Declining readings indicate financial conditions across markets and banking systems have loosened. Typically, when the Fed raises interest rates, financial conditions tighten.

If easier financial conditions lead to a reacceleration in economic activity, “It’s going to require us to do a lot more,”

Christopher Waller,

a Fed governor, said last month.

In turn, that could reverse much of the gains that have rippled across markets over the past few months—one reason some investors are cautioning against loading up on risky assets right now.

“A healthy dose of skepticism is warranted,” Mr. Grahn said.

He added that the range of forecasts for how the stock market will perform has been quite big in 2023. BNP Paribas believes the S&P 500 could fall as low as 3400 by year-end, while Deutsche Bank expects the index to climb to around 4500.

Goldman Sachs thinks the market will finish at 4000, not far above where it started the year. The index closed Wednesday at about 4119.

“I think what that’s telling you is we’re going to continue to have a lot of volatility in the markets,” Mr. Grahn said.

Not all investors are on the same page. Investors in riskier assets such as stocks and corporate bonds, which have seen spreads tighten in recent weeks, appear to see a greater chance that inflation comes down without significant weakness, said Blerina Uruci, chief U.S. economist at T. Rowe Price. But investors in less-risky assets such as Treasury securities are increasingly pessimistic about the economy and see inflation falling because of a sharp economic slowdown ahead.


Do you believe that inflation has peaked and that the Fed will lower rates by the end of the year? Join the conversation below.

The gap between three-month and 10-year Treasury yields grew to the widest since at least the early 1980s last month. Wall Street has historically viewed an inverted yield curve, when short-term bond yields exceed long-term ones, as a sign that a recession is on the way.

“We’re skeptical that this is at the dawn of a new economic rebound,” said Keith Lerner, co-chief investment officer at Truist Advisory Services.

Mr. Lerner added that, even if markets are correct and the Fed winds up cutting rates this year, there is no guarantee that stocks will immediately power higher.

The Fed’s first rate cut after the dot-com bust was in January 2001, about seven months after it stopped raising rates. It took until October 2002 for the stock market to bottom out, by which point the Nasdaq had tumbled to a six-year low. Similarly, during the subprime-mortgage crisis, the Fed’s first rate cut was in September 2007. Stocks didn’t find a bottom until March 2009.

“The Fed pivot isn’t a cure-all if it means the economy is weakening,” Mr. Lerner said.

Write to Akane Otani at [email protected] and Nick Timiraos at [email protected]

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