(Bloomberg) – Investors have just reversed the pace of the Fed's tightening campaign and pushed aside the Fed fears that have dominated them for 15 months.
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The S&P 500 index capped a fifth straight week of gains and is now higher than on March 16, 2022, the day the Federal Reserve implemented its most aggressive rate hikes in four decades. US equities are not alone – from the dollar to bond volatility to equity market positioning, key metrics are back near pre-500 basis point levels.
Markets, once tied to the Fed's efforts to slow economic growth and inflation, are now focused on the health of corporate balance sheets and the potential for an increase in capital spending as companies adapt for an AI boom.
Macroeconomic contribution in stock markets has fallen to 71% from 83% since March – the sharpest three-month decline since 2009, according to a model by Citigroup Inc.
“The Fed is likely to be a little less important than it has been over the next six to 12 months,” said Jonathan Mackay, Schroders' head of platform distribution. “Other global drivers and fundamental drivers will play a bigger role as the Fed potentially enters its pause phase.”
As the Fed signals that it is reaching the end of its rate hikes, Treasury investors are expecting volatility to ease after experiencing some of the largest daily swings in yields in years. Geopolitics and China's economic strength should regain prominence in investment theses.
“We used to know that the only reason the Fed will hike rates is because inflation is too high,” said Fiona Cincotta, senior market analyst at City Index. “Now it's going to be much more data-dependent.”
Markets had a strong first half of 2023, luring investors off the sidelines and forcing some of Wall Street's loudest bears to switch strategies. A measure of Deutsche Bank AG's aggregate equity positioning went overweight for the first time in more than 16 months, returning to pre-cycle levels last seen.
Volatility has fallen in bonds and equities: the ICE BofA MOVE index of expected US Treasury price movements is trading near its pre-tightening low, while the Cboe volatility index, which measures equities, is hovering at levels seen recently was achieved in 2020.
The dollar's interest-rate-driven strength has also faded as the Bloomberg Dollar Spot Index trades near April 2022 levels and is down almost 10% from its record high.
The S&P 500 Index posted its mildest reaction in two years on FOMC day. Though it was the first of 11 meetings where policymakers kept rates on hold, they also raised forecasts for higher borrowing costs from 5.6% in 2023, meaning two more quarter-point rate hikes or one half-point hike implied before the end of the year.
Contrast that with markets hanging on to every word the Fed officials said last year.
The bull market also conflicts with the 65 percent chance of a US recession within a year, economists estimate. The collapse of four regional banks and inversions along the US Treasury curve suggest an economic slowdown. Wall Street veteran Bob Michele believes there will be a recession by the end of the year, which will force the Fed to ease monetary policy.
For now, the US economy appears to have weathered the onslaught of interest rate hikes, with robust labor markets and mostly healthy corporate balance sheets. Among the biggest bears in the market were strategists at Bank of America, which raised its target for US equities and turned more optimistic on the economic outlook, forecasting a “later and more moderate downturn.”
But Peter Chatwell is not convinced that the economy or markets can long resist the pull of more restrictive policies.
“The rally is typical of a bear market rally and not an outright bull market rally,” warned Mizuho International Plc's head of global macro strategy trading. The price hike is “on weak foundations and vulnerable to a re-rating towards higher medium-term interest rates”.
Regardless of whether the bull market is real or not, it attracts investors. According to Bank of America, citing EPFR Global, global US equity inflows totaled $38 billion over the past three weeks, the strongest inflow momentum into the asset class since October.
“Investors appear to have finally thrown in the towel and are starting to chase the rally,” said Emmanuel Cau, head of European equity strategy at Barclays. “As long as the US recession continues to be pushed back, we believe stocks can continue to rise.”
– With the support of Lu Wang.
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