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Stocks slumped this week, with the S&P 500 index falling about 0.7%, the Nasdaq Composite slipping 0.5%, and the Dow Jones Industrial Average sinking 1.4% as a Federal Reserve interest-rate hike looks increasingly likely. But what if that hike kicks off the next leg of the bull market? The market-implied odds of a hike have risen dramatically, from 59% a week ago to 87% on Friday, per the CME FedWatch tool. That makes sense given that inflation reports this week show prices continuing to outrun the Fed’s 2% target. And with oil rising another 9% this week, the inflation pressure doesn’t seem to be abating anytime soon. Mix in the strong August jobs report we got the prior week, and the case for a rate hike seems clear. But how much would a quarter-point hike actually matter? Rates have already been climbing, with the 10-year Treasury yield zooming from 4.4% at the end of June to nearly 5% today, and the two-year yield rising by about the same amount. On Thursday, the 30-year yield settled at 5.36%, its highest level since June 2004. Put another way, the last time long-term yields were this high, America had not yet seen Will Ferrell ask, “I’m Ron Burgundy?” This spike certainly hasn’t been helpful for the stock market, which is about flat since June even as analysts have ramped up earnings expectations for 21 straight weeks. But it hasn’t been catastrophic, either. “Concerns over rates destabilizing equities are real, but tech euphoria creates a high bar for macro risks,” writes Benjamin Bowler, head of global equity derivatives research at Bank of America. In other words, excitement over artificial-intelligence is such a big driver that investors are shrugging off the rate rise. Bowler points out that this happened in the late 1990s as well, when the 30-year yield rose 2% and the Fed hiked by more than 1%, as the Nasdaq partied hard. “Expect equities to bounce hard from any pullback, as they did in the dot-com era and more recently,” he advises. So if the downdraft resumes, the buyers might come out in force. And they certainly won’t be dissuaded by slightly higher short-term rates. Especially if the move stabilizes the longer end of the bond market—which Mike Sanders, head of fixed income at Madison Investments, says is likely. He explains that at this point, a hike would show that Fed Chairman Kevin Warsh is serious about taming inflation. If, on the other hand, Warsh shies away from a hike after his vows to make high inflation “a thing of the past,” it could suggest that he’s “all talk,” says Sanders. This would hurt the Fed’s credibility and cause a real worry that inflation will be much higher for years to come. Following this logic, a hike could actually be a mildly positive event for long-term bonds and stocks as well. Bond investors hate high inflation, and equity investors are no fans of it either, particularly now that it is seriously hurting consumer confidence. This may explain why the S&P 500 rose 1% on Friday, snapping a four-day losing streak after the consumer price index report showed inflation has been slightly hotter than expected. The thinking, says one market-watcher, is that the Fed is now being forced into a hike that will preserve its credibility. It’s a confusing dynamic. Stocks are generally opposed to higher rates, which can slow the economy and make bonds relatively more attractive as compared with equities. But above all else, they value stability. When expectations of a Fed hike start rising, that tends to take a bite out of the market, and we probably saw that dynamic earlier in the week. Yet at this point, a widely predicted (and clearly warranted) Fed hike would bolster stability, quiet the fears of runaway inflation, and allow stocks to focus on what really matters: The AI buildout and the earnings bonanza it continues to precipitate. And the more investors focus on that, the better the market will do. Write to Alex Rosenberg at alex.rosenberg@barrons.com
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