The recent market rally could be an “unwanted development” for the Fed

On Wednesday, the Federal Reserve continued its efforts to tame inflation by raising interest rates for the fourth time in a row and announcing that more hikes are on the way.

Shares rose thereafter, with the S&P 500 jumping 2.6% on Wednesday and another 1.2% on Thursday.

The rally to the upside extended the reversal by about six weeks in what has been a bad 2022 for equities to date; As of Thursday’s close, the S&P 500 has rebounded around 11% from its mid-June lows.

The Fed usually ignores stock market moves, but the turnaround in equities has also coincided with an alarming turnaround in bond markets as well, which could create problems for politicians.

Long-term interest rates, which the Fed does not directly control, do not appear to be receiving Fed Chairman Jerome Powell’s message about further rate hikes. And that could potentially dampen the expected impact of rising interest rates, which is to help slow demand to slow inflation.

“We worry that some markets may see the pivot they want to see, instead of a transition from one phase of the policy to another that is naturally more data dependent,” analysts at Evercore ISI wrote Thursday.

Since the Fed meeting on June 15, the 10-year US Treasury yield has fallen by more than 0.70%, to just under 2.70% as of Thursday afternoon. As a benchmark for interest rate products, the decline could make longer-term credit products (eg business loans) cheaper than they were a month ago.

Mortgage rates, often the largest long-term debt for households, have fallen similarly since mid-June. The average rate on 30-year fixed-rate mortgages has fallen 0.5% in the past five weeks, standing at 5.3% as of Thursday.

The combination of higher stock prices and lower long-term financing costs ease financial conditions, potentially stable demand and complicate the Fed’s efforts to reduce inflation.

“[T]the substantial easing of financial conditions that occurred in response to [Wednesday’s] the meeting will ultimately be an unwelcome development for the Fed as it seeks to achieve price stability, ā€¯Deutsche Bank analysts noted Thursday morning.

For his part, Powell said Wednesday that financial conditions remain tight since the start of the year, adding that the impact of vastly higher long-term rates “should continue to moderate growth and help drive demand into a better balance with the offer “.

That is, unless conditions stop tightening further.

“We don’t check that second step”

Fed policy makes its way through the financial system in two stages: the first is short-term rates, which the Fed controls; the second is the longer-term rates, which are set by the markets but influenced by where the short-term rates are set.

The central bank began raising interest rates in March of this year, pushing up the rates used by banks to borrow from each other on an overnight basis.

But the second part of this transmission exacerbates broader financial conditions as longer-term rates, which affect corporate and consumer debt, are pushed up by markets.

Until, of course, investors begin to doubt the Fed’s ability or desire to further raise investor rates and price in the event of an economic slowdown, future interest rate cuts, or both.

“We don’t check this second step,” Fed Chairman Jerome Powell said Wednesday in response to a question from Yahoo Finance. “We will only do what we think needs to be done.”

US Federal Reserve Chairman Jerome Powell attends a press conference in Washington, DC, US, on July 27, 2022. The US Federal Reserve raised its benchmark interest rate by 75 basis points on Wednesday, the second in a row for that size. , as high inflation showed no clear signs of easing.  (Photo by Liu Jie / Xinhua via Getty Images)

US Federal Reserve Chairman Jerome Powell attends a press conference in Washington, DC, United States on July 27, 2022. (Photo by Liu Jie / Xinhua via Getty Images)

Up until a month and a half ago, the markets seemed to get the message. The US 10-year yield more than doubled in the first half of the year, from around 1.5% in January to a high of 3.43% in mid-June at the start of the hiking campaign.

But a reversal in recent weeks, despite the Fed’s insistence this week that it will continue to raise rates, signals expectations that a recession will support the Fed in rate cuts as soon as next year.

The Fed’s reading on the issue is that bond markets are pricing in the expectation that inflation will decline, which Powell says is “a good thing.”

For now, Powell has only promised further interest rate hikes, with little detail on the magnitude and pace of such upcoming moves. Powell articulated Wednesday that the Fed may pull back from its large rate hikes at some point, but said further “unusually large” moves, such as the 0.75% enacted in the last two meetings, remain on the table, depending on the data.

If financial conditions don’t seem tight enough, the Fed chief has suggested they’ll let the markets know.

“Of course, we will be watching financial conditions to see that they are adequately tight and that they are having the effect we hope they are having,” Powell said Wednesday.

Brian Cheung is a Fed, Business and Banking Journalist for Yahoo Finance. You can follow him on Twitter @bcheungz.

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