The Stock Market Slumps As Investors Realize Rates Will Remain High For A While

The financial markets are beginning to accept the likelihood of higher U.S. interest rates persisting for a longer period. This shift in sentiment comes after the release of the blowout private-sector jobs report by ADP for June and the prospect of another strong official labor-market reading on Friday.

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The data, which has been difficult to ignore, indicates that interest rates may stay elevated for an extended period. Following ADP's report of 497,000 private-sector job additions in June, more than double the forecasted number, the policy-sensitive 2-year rate briefly reached its highest level in 17 years, settling at 5%. The benchmark 10-year yield also finished above the 4% level associated with a healthy U.S. economy. Consequently, all three major stock indexes closed lower, with the Dow industrials falling 366.38 points or nearly 1.1%.

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Brian Jacobsen, Chief Economist for Annex Wealth Management, suggests that investors are now in an environment where the lows reached in the Dow industrials and the S&P 500 last October may hold. Jacobsen compares the current situation to the 2012-2015 period marked by a "taper tantrum" in U.S. yields, the Federal Reserve's need to tighten policy, and a resilient economy that experienced a jobless recovery.

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The recent market movements, driven by a combination of strong job gains, reduced quit rates, manufacturing weakness, and service-sector strength, have awakened market participants to the idea that the Fed's work is not yet complete. Jacobsen believes that while there may be dips, they are unlikely to lead to corrections or the start of a bear market. He advises investors to position themselves for a recovery in corporate earnings and sees plenty of opportunities to buy amid a choppy path.

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Investors and traders have spent much of this year preparing for the central bank to end its aggressive rate-hiking campaign and start cutting borrowing costs sooner than expected. However, inflation has not declined as much as anticipated, especially when considering core readings that policymakers prioritize. The labor market's upside surprises pose challenges to the Fed's campaign against inflation and have created volatility not only in stocks and bonds but also in other asset classes like gold and oil.

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Friday's nonfarm payroll report is expected to reveal a gain of 240,000 jobs for June, with a 3.6% unemployment rate. Analysts believe that a strong ADP private-sector report can serve as an indicator for the official figures that follow. Edward Moya, a senior market analyst at OANDA Corp., suggests that there is a possibility of even greater-than-expected job gains being reported on Friday, which could further impact investors.

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The recent increase in the 2-year rate above 5% indicates that the market is starting to recognize the "higher-for-longer" theme in interest rates. Moya warns that if the economy continues to display excessive strength, the Fed may need to deliver more rate hikes, potentially leading to a difficult stock market environment. Overcoming inflation will be crucial for the real economy to thrive, but it may entail navigating rough waters ahead.

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Higher interest rates, intended to tighten financial conditions, are providing additional income to savers. This group is benefiting first before the negative impact on borrowers can take effect. The ability to accumulate more savings during the Covid-19 pandemic has allowed a significant number of Americans to pay off debt, spend, invest, or increase their cash holdings. This dynamic might work against the central bank's efforts to slow the economy.

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Judith Raneri, a portfolio manager at Gabelli Funds, highlights that higher interest rates are enabling investors to make significant profits, which can be used to pay off debt or accumulate more interest on cash holdings. This interest income is becoming an important factor across the entire economy when the Fed's focus is primarily on achieving its 2% inflation target. Raneri expects the Fed to raise rates by 25 basis points in July and another 25 basis points in September, as the labor market remains robust until it begins to impact the economy.

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