Expectation Rearrangement...
Stock prices reflect the future expectations of market participants, and few things have as much of an impact on the path of economic activity as monetary policy from the Federal Reserve. However, even broad consensus among all market participants can’t be 100% accurate, and sometimes expectations need to be adjusted. For instance, when faced with persistent inflation that proved to be more sustained and less transitory than expected, the Fed adjusted and signaled the start of an historic rate-hiking campaign. Once it became clear that the Fed was willing to make rate hikes in the face of soaring price pressures, market participants had to adjust their expectations about upcoming Fed actions. The reaction to the reality of imminent rate hikes sparked a nine-month long decline in stock prices, with the overall market dipping by close to 30%, as market participants adjusted their future expectations to reflect the demand-sapping effects of restrictive monetary policy.

Bumpy Ride
After hitting a low point in October of last year, stocks began to creep back up after the Fed signaled they were stepping back from outsized hikes of 0.75% and ratcheting down to hikes of 0.50% and then 0.25%. From their lows in October 2022, stocks gained as much as 32%, reaching the highest point of this year at the end of July. However, it was not a smooth journey from October 2022 to July, and stocks have gone through more recent turbulence as well. After climbing 17% from their October lows, stocks dipped in December by 8%. By February, stocks had risen by nearly 12%, but then fell again by 9%.

Correction Territory
The steep declines of December and March were likely driven by reassessments of how many times the Fed would raise rates. Market expectations, as implied by the Fed Funds futures market, repeatedly underestimated the number of remaining hikes the Fed would make. The reactions to unexpected ongoing hikes may have played a primary role in sending stocks down during their last dips of 8% and 9%. Since reaching their latest high point in late July, stocks have lost up to 11%. A loss of 10% is often referred to as a correction, and though stocks have crossed into correction territory, so far, the drop is somewhat comparable to the recent dips in December and March.

Normalization Equation…
However, the current downturn likely has more to do with expectations about rate cuts than for rate hikes. Now that most market participants seem to think the Fed is nearly done, if not completely done making rate hikes, focus has turned from guessing the number of upcoming hikes, to guessing the timing of rate reductions. It may not be all that surprising for a shift in rate cut expectations considering that most economists along with the Fed, expected that the US would have fallen into a recession by this time. Stock market participants may have linked recession expectations with forecasts for the Fed to start lowering rates back down. Instead, the US economy has remained remarkably resilient, and a constant onslaught of upbeat data have wiped away expectations for soon and upcoming rate reductions. For stocks to stabilize, market expectations for the timing of rate cuts may have to adjust until there is enough alignment with the impacts of a stubbornly strong labor market on how quickly inflation falls to the Fed’s 2% target.

November 1, 2023