(Bloomberg) — A raging debate about the path of monetary policy is falling on deaf ears among traders who have just pushed the S&P 500 to a fresh record.
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Convinced a soft landing can coexist with five or more Federal Reserve rate cuts this year, they’re all in on a market that is already testing earnings-valuation boundaries which prior to the Covid outbreak hadn’t been breached since the early 2000s.
It’s a somewhat jarring stance when viewed alongside a batch of hawkish warnings from the Davos crowd, cautious Fedspeak and a dialing back of euphoria in the bond market over the potential for aggressive interest-rate cuts. Recent weeks have also been dotted with macro data showing the economy continues to hum as prints show consumer strength and a resilient job market.
“The solid earnings would require a decent, if not solid, economy. That many rate cuts imply an economy sufficiently weak to require aggressive Fed intervention,” said Steve Sosnick, chief strategist at Interactive Brokers. “I don’t see how we get both.”
After a wobbly start to the year, the S&P 500 scored a second weekly gain, pushing the index to a new high. Tech stocks led the way, with the Nasdaq 100 hitting a record and climbing almost 3% for the week. Meanwhile, Treasuries that closed 2023 with a historic rally have notched losses in the new year with yields climbing across the curve.
Read more: Bets on Soft Landing Push US Stocks to First Record in Two Years
This comes as a slew of US central bank officials push back on rate-cut speculation. Fed Bank of Atlanta President Raphael Bostic urged policymakers to proceed cautiously toward easing, while Fed Governor Christopher Waller appeared to question the need for aggressive rate cuts, at least for now. Accordingly, traders who ended 2023 expecting six rate cuts this year have pared the wager to five and become less certain they will begin in March as they were at year-end.
Elsewhere, economic data showing elevated consumer confidence and lower inflation expectations is being absorbed well by traders, for now. US retail sales rose at the strongest pace in three months in December while US consumer sentiment soared in early January to the highest since 2021 as short-term inflation expectations slipped to a three-year low.
“‘Good news is good news’ is working right now,” said Peter Tchir, head of macro strategy at Academy Securities. “It takes some recession fears off the table.”
More often than not, when rate cuts occurred in the past as a response to “growth worries,” most of the market pain happened in the run-up but was followed by a gain once the easing began, according to an analysis of 10 such cycles since 1984 by Goldman Sachs. But when cuts reflect the normalization of monetary policy rather than an economic slowdown, equities have tended to rally consistently both in the year before the first reduction and for two years afterward, the bank found. Even a scenario of strong economic growth and higher inflation has delivered positive, albeit below-average, performance to stocks historically, data compiled by Ned Davis Research show.
Goldman projects above-trend growth and five Fed rate cuts this year, favoring long risk positions, but sees opportunities to add protection as volatility levels remain low.
Yet for Deutsche Bank’s Jim Reid, the extent of rate cuts that have been priced into the market would only make sense if a downturn is on the horizon. This doesn’t appear to be the case at the moment.
“Our highest conviction thought so far this year has been that the least likely scenario would be the level of rate cuts priced in by the market occurring without a recession,” he wrote in a note. “Such a scenario has felt completely out of place with history and still does.”
Traders have been blindsided repeatedly over the last few years by overestimating the odds of easing when inflation has surprised to the upside. That’s left Wall Street on edge after at least six instances over the past two years when the Fed was derailed from a dovish pivot that market participants were betting on.
Jim Caron, co-chief investment officer at Morgan Stanley Investment Management, reckons that if the number of rate cuts are less than six this year, “then naturally bond yields have to rise, and because there is high correlation between stocks and bonds right now, that’s going to put pressure on the equity markets,” he told Bloomberg Television on Thursday.
While risk-on bets have lifted stocks, much of the advance is the result of gains in technology firms that have a habit of posting profit growth across business cycles. Tech equity funds saw the biggest two-week inflow since August at $4 billion, according to Bank of America Corp., citing EPFR Global data. This leaves the Nasdaq 100 priced above 30 times profits, among the higher readings on record.
“Equity markets have clearly priced in a very, very optimistic scenario — in a way that might not turn out to be so optimistic,” said Tatjana Puhan, chief investment officer at Copernicus Wealth Management.
–With assistance from Isabelle Lee, Michael Mackenzie and Edward Bolingbroke.
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