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Middle East Conflict Prevents Stocks Rally Despite Powell’s Dovish Comments

Published 10/20/2023, 07:10 AM
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  • Stocks experienced a turbulent day on Thursday after Fed’s Powell contributed to market volatility
  • Investors were already grappling with rising bond yields, the ongoing Israel-Hamas conflict, and the series of corporate earnings reports for the third quarter
  • Powell hinted that the Fed likely won’t raise rates in November, however, he left the door open for a potential hike in December, leaving risky assets like stocks in a difficult place
  • The S&P 500 has been trading in a volatile fashion in recent days amid rising geopolitical tensions, as well as rising bets that the Fed will hold rates higher for longer than initially anticipated.

    This week’s major event took place on Thursday when the Federal Reserve Chair Jerome Powell spoke at an event and reiterated the central bank’s preference for keeping interest rates steady at the next meeting.

    While Powell hinted that the Fed is likely to hold rates at current levels on November 1, he also left open the possibility of future rate hikes if the economy continues to show resilience. In response to Powell’s speech, the dollar declined, short-term Treasury yields dropped while long-term yields rose, leading to a steeper yield curve.

    Elsewhere, economic reports presented a mixed picture, with a decrease in applications for U.S. unemployment benefits to the lowest level since January. Sales of previously owned homes fell to their lowest level since 2010, primarily due to worsening affordability.

    "Companies on earnings calls may warn about the outlook and risks ahead, but they are still holding on tight to their workers as good help is increasingly hard to find," said Christopher Rupkey, chief economist at FWDBONDS in New York.

    "The economy and labor markets are simply not slowing down, and time will tell if this will reignite the inflation fires that until recently were looking contained."

    While some of these developments were positive for stocks as yields started falling during Powell’s speech, gains were short-lived amid reports of renewed tensions in the Middle East, ultimately sending major indices lower.

    Given the persisting geopolitical risks, shaped by the reports of a U.S. base in Syria being targeted by drones and a U.S. destroyer intercepting cruise missiles and drones in Yemen, it is hard to see risky assets prosper in such an environment.

    Fed Unlikely to Hike in November

    Speaking at the Economic Club of New York, Chair Powell hinted that the recent increase in long-term Treasury yields might provide room for the central bank to pause its historic run of interest-rate hikes, given the recent progress in addressing inflation.

    Powell's comments align with those of his colleagues who have indicated their intention to keep short-term interest rates steady at the next meeting in late October. This very likely means that the Fed will keep rates at current levels on November 1.

    “We have to let this play out and watch it, but for now, it is clearly a tightening in financial conditions,” Powell said.

    He added that the reasoning behind raising interest rates is to “affect financial conditions, and higher bond rates are producing tighter financial conditions right now.”

    The rapid rise in long-term rates in the past month, which could potentially act as a drag on economic growth, effectively serving as a substitute for an additional Fed interest rate hike if these higher borrowing costs persist.

    The yield on the 10-year Treasury note approached 5%, marking a 16-year high, and was up from the previous day. Higher yields are negative for stocks as investors are likely to opt for safe-haven assets like bonds given high returns. In addition to higher yields, mortgage rates approached 8% on the 30-year fixed rate loan – the highest level in 23 years.

    Hike Could Be on the Table in December

    On whether the Fed will raise rates again, Powell opted to use the word “could” instead of “would,” a hint that the central bank may have stopped hiking rates.

    “Given the fast pace of tightening, there may still be meaningful tightening in the pipeline,” Powell added.

    According to CME’s FedWatch Tool, there is a 98.4% probability that the Fed will keep rates at these levels at the upcoming meeting. Following Powell’s speech, the market is now pricing in a 20.3% probability that the Fed will raise rates in December, down from 29.9% before Powell delivered his remarks.

    “Powell is not going to signal a hard stop to rate hikes,” said Tim Duy, chief economist at SGH Macro Advisors.

    “He’s always going to dangle the possibility of another hike. But the data needs to change markedly to push the Fed in that direction.”

    The central bank has embarked on an aggressive path of hiking rates to slow down the hot economy. The Fed’s preferred inflation gauge, which excludes volatile food and energy prices, estimated that core prices probably increased by 3.7% in September.

    This figure marks a decrease from 3.9% in August and a significant decline from 4.9% at the end of the previous year. However, these numbers are still way above the Fed’s target of 2% for inflation.

    “Inflation is still too high, and a few months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal,” Powell noted.

    “We cannot yet know how long these lower readings will persist, or where inflation will settle over coming quarters.”

    Conclusion

    Analysts believe that the challenge moving forward is whether robust consumer spending will continue to support job growth and economic demand in a way that helps curb inflation. Should inflation remain persistent, it might necessitate further tightening of monetary policy.

    Vital Knowledge’s Adam Crisafulli believes that the recent growth and inflation environment may not be as overheated as some official government statistics indicate, which raises concerns about the rapid increase in long-term Treasury yields.

    He argues that a potential decline in yields, while anticipated, would likely provide only a temporary relief to stocks. Crisafulli believes that equities may struggle to rally despite falling yields, as investors start pricing in a cooler growth landscape.

    ***

    Shane Neagle is the EIC of The Tokenist. Check out The Tokenist’s free newsletter, Five Minute Finance, for weekly analysis of the biggest trends in finance and technology.

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