Despite High-Intensity Tightening Warnings... Wall Street Betting on the 'Fed's Bluff'

[Image source=AP Yonhap News]

[Asia Economy New York=Special Correspondent Joselgina] Is it the Federal Reserve’s (Fed) ‘bluff’ or Wall Street’s ‘misjudgment’?

Despite senior Fed officials repeatedly signaling that they will continue raising interest rates until inflation is clearly under control, the financial sector’s response remains lukewarm. As expectations grow that rates will be cut in the first half of next year, the New York stock market is continuing its rally. This reflects a revival of the market’s long-standing belief in the so-called ‘Fed put’ that has persisted for decades.

On the 18th (local time), the S&P 500 index, composed of large-cap stocks, closed at 4,283.74, up 0.23% from the previous session. This marks an approximately 17% increase from the June low. Meanwhile, the benchmark 10-year U.S. Treasury yield is trading around 2.88%, down 0.59 percentage points from its June peak. This means that bond prices, considered safe assets, have risen accordingly during the same period.

These movements in stock prices and Treasury yields suggest that the market is anticipating a slowdown in the Fed’s pace of rate hikes soon. The Wall Street Journal (WSJ) reported that day, “Although the Fed says it will continue raising rates, Wall Street thinks this is ‘bluffing,’” analyzing that this reflects the judgment that inflation has peaked and the expectation that the Fed will shift to rate cuts next year.

Fed officials continued to deliver hawkish remarks that day. James Bullard, President of the Federal Reserve Bank of St. Louis, stated in an interview with the WSJ that a third consecutive giant step (a 0.75 percentage point rate hike) would be necessary at the September Federal Open Market Committee (FOMC) meeting. He said, “It cannot yet be said that inflation has peaked,” and flatly rejected expectations of rate cuts next year.

Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, also said that economic slowdown could be tolerated to ease inflation, emphasizing that “expectations that the Fed will turn to rate cuts within 6 to 9 months are unrealistic.” Mary Daly, President of the Federal Reserve Bank of San Francisco, pointed out that “rates should be maintained at the current level for some time after hikes,” warning that “cutting rates again too soon would cause confusion.”

Experts attribute the market’s lack of reaction to the series of hawkish remarks to the expectation of the ‘Fed put.’ The Fed put refers to the Fed’s actions to cut rates or engage in quantitative easing to supply liquidity to the market whenever financial markets face difficulties.

The WSJ noted, “Earlier this year, the market did not expect a Fed put, and the stock market recorded the worst first half since 1970,” but added, “Now investors are beginning to believe that the Fed will respond despite contrary signals.” It also mentioned that this expectation of the Fed put dates back to the 1980s. Whenever stock prices plunged sharply?such as during the 1987 Black Monday crash, the 1998 Russian financial crisis, and the early 2000s dot-com bubble?the Fed quickly acted to stabilize the market.

Despite the Fed’s two consecutive giant step hikes last month, investors paid more attention to Fed Chair Jerome Powell’s remarks about “unusually large hikes” and that “the pace of hikes will slow down eventually.” Jim Paulsen of the Leuthold Group said, “Even if the Fed is hawkish now, it could turn dovish within a few months.”

However, warnings are mounting that the expectation of the Fed put is excessive amid uncertainty about how long the Fed will continue raising rates and at what level it can achieve the 2% inflation target. Wei Li, Global Chief Investment Strategist at BlackRock, the world’s largest asset manager, said, “The market is too far ahead. It already reflects more aggressive rate cuts than we expect,” adding, “While the Fed will eventually shift policy, it will fall short of market expectations.” Wall Street investment banks predict that the New York stock market will decline further by the end of this year. Bank of America (BoA) forecasts the S&P 500 could drop 16% to around 3,600.

The WSJ pointed out that Wall Street’s judgment that the Fed is bluffing could be problematic not only for investors but also for the Fed itself. Monetary policy is difficult to be effective when market trust is eroded.

Recent market rallies are also seen as making the Fed’s path more difficult. James Drago, Head of Asset Allocation for the Americas at UBS Global Wealth Management, evaluated that “(due to the sharp rise in stock and bond prices) financial conditions have loosened further, which could weaken the Fed’s efforts to curb inflation.”

Meanwhile, it has been confirmed that quant funds, which make investment decisions based on computer programs, have recently been expanding their bets on U.S. stocks. The Financial Times (FT) reported that these quant funds’ bets have fueled the sharp rebound in the New York stock market, which has added $7 trillion (approximately 9,292 trillion won) in value since June.

This content was produced with the assistance of AI translation services.