The Federal Reserve is cooling the economy, but stocks are hot. what to give

Stocks tumbled in June as investors bet inflation has peaked despite the Federal Reserve suggesting its campaign to cool the economy by raising rates isn’t over. It has soared from its lows.

Rising interest rates usually have a negative impact on stock prices because they increase costs for companies. The Federal Reserve recently argued that the central bank needs to raise interest rates further to curb stubbornly high inflation. Still, the S&P 500 is on an uptrend, registering gains over the past three weeks, up more than 12% from its June 16th low.

Investors seem to be choosing to focus on easing recession fears rather than worrying that a booming economy will prompt the Fed to raise rates more aggressively.

Wednesday’s latest consumer price index data will put this line of thinking to the test. A widely watched report is expected to show that overall inflation eased in July, down from a 9.1% pace in June to 8.7% year-on-year, according to a Bloomberg survey of economists. rose.

Investors have gained momentum in recent weeks as companies’ quarterly earnings reports have beaten expectations. U.S. businesses continued to hire new workers at a solid pace last month, according to the latest data on Friday, suggesting the economy is resilient to rising interest rates. . But it could also be seen as a sign that the Fed needs to do more to cool the economy and keep prices down, increasing the risk that higher interest rates will lead the economy into recession.

David Donabedian, CIO of CIBC Private Wealth Management, said: “The ‘peak inflation’ argument is so entrenched in market sentiment that jobs numbers are likely to be interpreted as anti-recession. I think it did,” he said.

Investor expectations about where the Fed’s key rate will end the year are higher than this month, but investors still expect the Fed to not only halt rate hikes next year, but to reduce rate hikes somewhat. This is a change from expectations in June, when investors were more closely aligned with the Fed’s own forecast that rate hikes would continue through 2023.

In the optimistic case, the Fed could cut rates next year if inflation is contained without hurting the economy and it turns out that tightening policy is no longer needed. A survey of households released Monday by the Federal Reserve Bank of New York showed that consumer inflation expectations fell sharply, supporting the view that the inflationary spiral has not taken hold.

But Donabedian warned that investors may be overly optimistic even if inflation drops from current levels. If headline inflation falls to his 8.7%, that’s well above his Fed’s policy target of 2%.

With such optimism driving stocks higher, any shock that points to accelerating inflation could send financial markets down sharply. As a result, Alan McKnight, chief investment officer at Regions Bank, said he was “less optimistic” than financial markets indicated.

Other factors may explain the seemingly puzzling market dynamics.

August is typically a quiet month for stocks, with lower trading volumes as traders move away from their desks for the summer holidays, making prices more susceptible to sharp moves.The S&P 500 traded on ticker SPY. Trading volumes in the $375 billion exchange-traded fund tracked fell to its lowest level since November last month.

Movie operators AMC Entertainment have jumped more than 60% this month, while Bed Bath & Beyond has jumped more than 120% this month.

These mixed trading patterns make interpreting trends in financial markets even more difficult, already grappling with rising inflation, rising interest rates and rising recession fears.

“There are many reasons for the abnormal economic environment, right?” said Ben Snyder, market strategist at Goldman Sachs. “So it’s hard to say that something is abnormal or normal, because everything is abnormal these days.”

The S&P 500 has fallen in recent days, but the drop is smaller than last month’s gain, suggesting investors may be bracing for Wednesday’s inflation rate before making their next meaningful move. suggests. The index fell 0.4% on Tuesday.

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