Friday's Market Minute: The Stock Market Is Missing A Clear Positive Catalyst

U.S. stocks have given up all last week’s gains as the market reprices the expectations of inflation and Fed policy. Since the CPI report on Tuesday, the Fed policy-sensitive two-year rate is up as much as 30 basis points, which has suppressed risk-taking. Currently, Fed fund futures are pricing a peak terminal rate of nearly 4.5%, up more than 60 bps since Aug. 25, the day before the Jackson Hole symposium.

As a result, rates across the Treasury curve are pushing higher and credit spreads are widening. The market has become 20% cheaper during this year’s sell-off as the aggregate earnings multiple has gone from 22 to 18. However, as Treasury rates continue to rise on the back of lower earnings, the earnings yield premium for stocks narrows, which induces buyers of risk assets to wait for cheaper prices.

The Fed meets again next week, and the talk of a full percentage point increase has become a possibility. Right now, the Fed is almost certain to hike by 75 basis points. Confidence that we are at or near peak inflation is dented, but not broken. Price action this week serves as a reminder that, as was the case on the way up, the path back to 2% inflation will likely be littered with unexpected surprises.

Inflation is still unanchored, and the Fed is at risk of losing credibility, which may lead it to raise rates faster than projections suggest. Investors who are eagerly waiting for a Fed policy pivot must realize the loss of credibility from reversing policy before the inflation subsides will require much higher interest rates and a far larger long-run economic cost of lost output and high unemployment.

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