(Bloomberg) — Wall Street traders cheered Wednesday when Federal Reserve Chair Jerome Powell signaled he doesn't expect imminent interest rate hikes despite inflationary pressures. The celebration did not last long.
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Briefly, US stocks rose to unleash their biggest post-policy meeting rally since December, while Treasury yields fell more than 10 basis points across maturities. The relief trade began when Powell told reporters “the next rate move is unlikely to be a hike.”
The problem is that Powell did not explicitly indicate that rate cuts would come this year either, and said it would likely take longer for central bankers to gain enough confidence in the downward path of inflation to consider easing policy. This reality check led to a surprise reversal in stocks, which ended lower during the day. Treasury yields pared some of their decline, with the two-year policy-sensitive yield holding below the 5% threshold — but not by much.
“Powell made clear that the hurdle to raising interest rates is incredibly high,” said Michael de Passe, global head of interest rates trading at Citadel Securities. “They ultimately view the price level as restrictive, that is undeniable. Is it restrictive enough, and how long does it take for it to seep into the economy? These are the questions now.”
The fact that the market reacted at all to the idea of a possible rate hike not being on the table shows how much sentiment has shifted since the start of the year, when the consensus called for multiple rate cuts and an expected steady downward trend in inflation. Expectations of higher interest rates were few and far between.
But recently, investors — especially in the world of Treasuries — have had reason to worry about a potential hawkish pivot from the Fed, as the U.S. economy remains resilient, with job creation growing stronger and inflation proving difficult to tame. Bond traders cut their expectations for a rate cut to just over one in six tranches by a quarter of a percentage point at the beginning of January.
The April sell-off in stocks and bonds that pushed two-year Treasury yields above 5% and sent the S&P 500 tumbling to its worst monthly loss since October illustrates the tension that has been building ahead of this week's Federal Open Market Committee meeting. Potentially pivotal data remains: Friday's April jobs report is expected to show strong job growth, while more inflation reports are due in the coming weeks. Central bankers will have to weigh all of this.
“The FOMC appears determined not to let the market stray too far from its base case of strong growth, steady inflation, and an intent to taper later this year,” Citigroup strategists led by Stuart Kaiser wrote in a note, referring to monetary policy. Formation of the Federal Open Market Committee. “The result was a big back-and-forth trading day.”
Powell highlighted the risks for investors when he said that while he believes current interest rate policy is “constrained, and we think it will be sufficiently constrained over time,” it “will be a question that the data will have to answer.”
Even as Powell acknowledged the lack of recent progress toward the Fed's 2% inflation target this year, his signals that cuts are more likely than higher rates were enough to calm the market, at least initially. Whether that ensures a sustainable rise for stocks is another matter.
What Bloomberg strategists say…
“Powell: Interest rate cuts before the end of the year are still on the table. Takeaway: Interest rates are capped but the Fed will ease if unemployment rises much further from here. The Fed has an easing bias.”
— Edward Harrison, Markets Live Blog Contributor
“I was more confused trying to figure out what Powell said to make stocks rise so sharply,” said Steve Sosnick, chief strategist at Interactive Brokers. “Sure, he said it wasn't necessary to raise interest rates and downplayed concerns about stagflation, but it wasn't worth a speculative spike.”
As for how long the latest bond easing rally will last, Citadel de Pas warned that although a bounce “makes sense,” the market is approaching its limits.
“It has already run out of steam with the market pulling back from the yield lows,” he said. “The market may have a harder time operating more because we are in a data-driven place.”
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