Stock market could ‘take it hard’ as expectations grow for a 6% fed funds rate

U.S. stock investors are clearly not too happy with what Federal Reserve Chairman Jerome Powell has said in the past two days. And there’s reason to think they’ll get even more dissatisfied in the weeks and months to come amid growing expectations that the fed funds rate may reach 6% this year, one of the highest levels in the past two decades.

Rick Rieder, chief investment officer of global fixed income for New York-based BlackRock Inc.
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put a 6% level for U.S. interest rates on the map following Powell’s first day of testimony to Congress on Tuesday. BlackRock is the world’s largest asset manager, overseeing almost $8.6 trillion as of December. Its view has only gained further traction as Powell testified again on Wednesday, according to FHN Financial’s Chief Economist Chris Low and Ben Emons, a senior portfolio manager at NewEdge Wealth, who are both in New York.

Powell took pains on Wednesday to clarify that policy makers have not yet made any decision about the size of March’s rate hike and are not on a “pre-set” course, helping to take some of the sting out of his otherwise hawkish message this week. U.S. stocks finished mostly higher, though the policy-sensitive 2-year Treasury yield
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inched further above 5%, and the Treasury curve went more deeply negative in a worrisome sign about the economic outlook. The ICE U.S. Dollar Index
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rose to its highest level of the year, and traders factored in an 77.9% chance of a half-percentage-point Fed rate hike on March 22.

With investors and traders largely focused on the size of the Fed’s next interest rate hike in two weeks, it’s the most likely path for interest rates over the next handful of months that has the potential to roil financial markets even further. Fed funds futures traders now see a 46.6% chance that the fed funds rate will get to 5.75%-6% or higher by July, and a 50.2% chance of that happening by September, according to the CME FedWatch Tool. That’s up from a current fed funds rate target range of between 4.5% and 4.75%.

Meanwhile, more economists are revising their fed funds rate forecasts to 5.75%-6%, according to FHN’s Low.

“Powell’s comments this week certainly suggested that the equity markets have been a little too overconfident in the prospects of a soft landing through the course of 2023,” David Keller, chief market strategist at StockCharts.com in Redmond, Washington, said in an email to MarketWatch on Wednesday.

“Growth stocks, in particular, have thrived on the expectation that inflation would quickly become a non-issue and equities would resume a more normal growth-driven rally phase,” Keller said. “Our main equity benchmarks, like the S&P 500 and Nasdaq Composite, are very growth-oriented, so higher rates suggest limited upside for these benchmarks until interest rates have reached their peak for the cycle.  After what we have heard this week, it appears that the finish line is farther away than investors thought.”

Growing expectations for a 6% fed funds rate threaten to undermine the S&P 500 and Nasdaq Composite, which are off to their best start to a year since 2019. The S&P 500
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is up 4% for the year through Wednesday, versus 9.42% through the same period in 2019. The Nasdaq Composite
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is up 10.6% on a year-to-date basis, versus 11.65% over the same time three years ago.

The risk of a 6% fed funds rate has been around since at least last April and resurfaced again in February, when it emerged as a slim chance in fed funds futures trading. Until Powell’s testimony this week, financial markets largely ignored the risk. The fed funds rate hasn’t been at or above 6% since March 2000 to January 2001, when Alan Greenspan led the Fed.

“A 6.0% terminal rate expectation, if widespread, would likely see the dollar extend the recovery that began in February,” said Marc Chandler, managing director at Bannockburn Global Forex in New York.

In addition, “the stock market would take it hard,” with the S&P 500 likely to fall near 3,800-3,850 — the level that corresponds to the “congestion” seen at the end of last year, he said. “It is an educated guess on momentum and psychology more than a statement about earnings or growth.” Such a move could occur quickly and be triggered by more hawkish comments or rate expectations from the Fed, a high reading on the next consumer price index, and “another very strong employment report.” 

The 2-year yield “could head toward 5.50% if not a little higher,” while the 10-year yield may not rise much above 4.25% — implying a further inversion of the spread between those two rates, Chandler said in an email to MarketWatch. Moreover, “the market would judge a hard landing [as] more likely.”

On Tuesday, the S&P 500 and Dow industrials
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booked their worst day in two weeks after Powell told the Senate Banking Committee that the ultimate level of rates is likely to be higher than previously thought, and that the Fed would be prepared to accelerate the pace of rate hikes if needed. The Nasdaq also dropped 1.3%.

Powell reiterated the same message to the House Financial Services Committee on Wednesday, yet couched it in more flexible terms.

At New York-based NewEdge, which oversees about $12 billion in assets, Emons said that the chairman has nonetheless “accomplished one thing with his pragmatic messaging: a 6% fed funds rate is quickly becoming the consensus.”