The Fed-Rate Bet Rethink Rattles Wall Street

Investors' mood was also soured by geopolitical tensions and dire forecasts from Walmart Inc. and Home Depot Inc. in the aftermath of a surge in Treasury yields that took the wind out of the stock market.

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Wall Street's increasing fears that the Federal Reserve will not be able to end its war against inflation - let alone pivot - have continued to burn bond investors who had been betting on the possibility of rate cuts this year at one point. The US yields reached new highs for 2023 as traders ramped up their Fed wagers and raised their expectations for the future. The last group of assets to join the so-called "everything rally" - equities - are now showing signs of exhaustion as the rally seems to be winding down.

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A sell-off that swept across every major group within the S&P 500 wiped out the index's monthly advance and sent it on its way to its worst slump since mid-December after a selloff that swept across every major group. Shares of the company fell by over 90%. There was a 2% drop in the Nasdaq 100 due to losses in tech stocks. The Cboe Volatility Index, which had remained stubbornly low earlier this year, jumped for a second day and climbed to about 23 on Wednesday. A two-day decline in the dollar came to an end yesterday.

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Although recent economic data indicate that the US may be able to avoid a recession, Morgan Stanley's Michael Wilson says equities' risk-reward ratio looks "very poor." Stocks are at their most expensive levels since 2007 on a measure of equity risk premium, which doesn't bode well for the market.

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According to Liz Young, head of the investment strategy at SoFi, the equity markets feel like they're overpriced given where we are at the moment, given the state of the economy. “It is obvious that the Federal Reserve still has a lot left to do, and we all know that the process of implementing monetary policy changes can have long and variable lag times before they can make their way through the economy. I find it difficult to take a look at this in this environment and say, "Yes, I think we should be paying 18 times forward earnings in this market."

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A number of Wall Street analysts have also expressed concern about the excesses of the stock market recovery.

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A JPMorgan Chase & Co. strategist, Mislav Matejka, has said that bets on a resilient economy and a Fed pivot are premature, while a Bank of America Corp. strategist, Michael Hartnett, predicts the S&P 500 to fall to 3,800 points by March 8, meaning a decline of about 7% from its last closing price. In comparison to Wilson's outlook, he holds a much more pessimistic view of the index, and he believes the index could plummet to as low as 3,000 by the start of 2023 - a 26% drop from Friday.

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Cantor Fitzgerald's Eric Johnston said he remains a bearish investor on equities - and he remains very convinced of this. There can be no doubt that Johnston disagrees with the view that there will be no recession in the US, but that the economy may instead experience a soft landing or no landing at all. I believe that the current performance of the economy is not an accurate indicator of what the economy will look like in six to twelve months from now, he stated.

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In addition, solid economic data continue to pose a challenge to Fed policy. 

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Although the US service sector regained its footing in February, equities suffered Tuesday, suggesting a strong economy is maintaining some pricing power.

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According to Jeffrey Roach, chief economist at LPL Financial, "A tight labor market coupled with resilient consumer demand is likely to push the Federal Reserve to continue raising interest rates into the summer months.". “The investor should anticipate volatility until markets and central bankers are able to reach an agreement on what interest rates are expected to do.”

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In the short term, swaps are showing a firm conviction on the part of the market that the Fed will continue to push rates higher over the coming months, with predictions that the Fed will hike rates by 25 basis points in March, May, and June. Currently, investors are pricing in the possibility of the federal funds rate rising to around 5.3% by the end of June. Compared to just three weeks ago, when the unemployment rate was perceived to be at 4.9%, that number is low.

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Morgan Stanley Wealth Management's chief investment officer, Lisa Shalett, said valuations incorporating ultra-modest risk premiums would likely be extremely vulnerable to market shocks if rates stay close to 5% for longer. “Investors should be aware that a 'higher-for-longer' Fed will not just reset the terminal rate, but also the longer-term neutral rate, causing headwinds to long-duration valuations as a result."