Further Volatility Expected as Market Adjusts to Higher Interest Rates

After a strong January, markets continued to rally in early February, only to roll over and end the month down. Fears about inflation rebounded, and worries that the Fed would hike rates further and faster-dominated markets. While the economic data remained solid, this good news was bad news for markets, as it was seen as a sign of higher inflation and interest rates.

Looking Back

The markets. For the actual numbers, the S&P 500 lost 2.44 percent in February, while the Dow Jones Industrial Average dropped 3.94 percent. The Nasdaq Composite held up the best of the three, with the technology-heavy index down 1.01 percent.

International markets also dropped: the iShares MSCI EAFE ETF (NYSE:EFA) Index fell 2.09 percent in February, and the MSCI Emerging Markets Index—down 6.48 percent—suffered the largest losses. Even fixed income got hit, with the Bloomberg Aggregate Bond Index down 2.59 percent, as the 10-year U.S. Treasury yield jumped from 3.39 percent at the start of the month to 3.92 percent at month-end.

Inflation. The decline was due to the surprisingly strong inflation numbers reported for January, as both headline consumer and producer inflation came in above expectations. With inflation heating up again, markets started to price in faster rate increases from the Fed, taking the yield on the 10-year U.S.

Treasury notes are up more than half a percentage point, which was a significant increase. Higher interest rates typically mean lower stock and bond values, and that is just what we saw. Looking back, the rise in rates appears reasonable, given the new data. Looking forward, Fed officials have signaled that they are watching, and the market’s worries about higher rates are realistic. This could be a headwind for markets over the next couple of months.

Economic growth. While financial markets pulled back last month, the economy continued to show signs of strength. Hiring was strong, and consumer confidence in present conditions ticked up, leading to higher consumer spending growth. Service sector business confidence held on to its gains for a second month of growth. And while there was a slowdown at the end of last year, the economy appears to have rebounded since the start of 2023 and continues to grow—so a recession is not likely in the immediate future.

Looking back, this continued growth, especially on the job and consumer spending side, may have driven the resurgence in inflation. As long as growth continues, the Fed has indicated it is likely to keep raising rates, so markets now expect more rate increases and a higher ultimate peak interest rate.

Looking Ahead

Earnings and valuations. Despite the headwind from higher rates, some potentially good news is ahead. With the economy looking healthier, earnings may do better than expected. While the current data shows they are beating expectations, it is much less than usual. With a stronger economy, those beats may increase.

While earnings may do better against expectations, valuations will likely adjust as rates rise again. We should get more color on this as Fed officials continue to comment and the inflation data evolves. Looking forward, markets will likely face more headwinds over the next few months.

Market volatility. In the short term, the economy is improving, but markets may struggle as the Fed continues to prioritize bringing inflation down. March is likely to be tougher for markets compared to the start of the year. At the same time, as we look ahead, a strong January has historically been a positive sign for the year as a whole. We can reasonably expect more volatility in the short term, but the longer-term picture remains more positive.

Political and international concerns. Beyond the economic and policy angles, March also faces challenges from politics. The federal debt ceiling was hit again in January, and the Treasury is now using extraordinary measures to pay the bills. While this will be resolved, it will likely be at the last minute, as it has been before. Until then, the rising uncertainty will also weigh on markets. With the Ukraine war underway and China’s Covid-19 reopening still uncertain, multiple risks will also act as market headwinds this month.

The Long View

Looking back, February had good economic news but weak market results. And March may be the same. If it is, the prospects for the rest of the year continue to look good. That’s the bottom line here. While we do have headwinds, the current adjustment in interest rates should help the economy and markets end up in a better place. Over time, we should see the same kind of economic resilience as those improvements continue.