The Widening Gulf between Financial Markets and the Federal Reserve

The expectations of financial markets and the Federal Reserve are drifting apart as doubts arise about the central bank's ability to maintain its higher-for-longer stance on interest rates.

Recent data suggests that the U.S. economy still has significant momentum, with third-quarter economic growth surpassing expectations and September's headline PCE inflation exceeding forecasts. However, despite these positive indicators, traders in fed funds futures continue to believe that there will be no action from the Fed by December, with a probability exceeding 70%.

Additionally, these traders have increased the likelihood of a rate cut by May to 40.2% as of Friday. At the same time, Treasury yields showed mixed movement, with the policy-sensitive 2-year rate experiencing little change.

Divergence of Expectations

It is not unusual for there to be a disparity between market expectations and the Fed's stance. Traders rely on the possibility of a U.S. recession to mitigate inflationary pressures. Interestingly, this divergence is unfolding in the midst of ongoing tensions in the Middle East, which heighten the risk of an oil shock. Furthermore, there is mounting evidence that inflation is taking longer than anticipated to reach the Fed's 2% target.

Conclusion

As expectations between financial markets and the Federal Reserve continue to diverge, it remains uncertain whether the central bank will be able to maintain its current interest rate trajectory. With geopolitical tensions and sluggish inflation complicating the economic landscape, the path forward for the Fed is increasingly uncertain.

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The Market versus the Fed: A Game of Chicken?

According to Adam Turnquist, the chief technical strategist at LPL Financial, there is a noticeable discord between what the market is suggesting and what the Federal Reserve is indicating. He believes that eventually, these two will align, but until then, expect more volatility and a high-stakes game.

Turnquist made this observation during a phone interview last Friday. He mentioned that the market was anticipating discussions about rate cuts at this time of year. However, the Fed has remained steadfast in its tone, giving no indication of a significant change. Turnquist thinks that policymakers would only consider cutting rates if there was a recession or if they believed they had successfully conquered inflation. Neither scenario has unfolded yet.

Interestingly, one estimate from the Atlanta Fed's GDP Now prediction indicated a growth rate of 2.3% for the fourth quarter as of Friday. This figure suggests a positive outlook for the economy.

On the inflation front, there are some concerns. The Fed's preferred inflation gauge, the PCE price index, revealed a monthly increase of 0.4% in the headline inflation rate for September. Additionally, the narrower monthly core gauge saw a 0.3% increase. According to Will Compernolle, a macro strategist at FHN Financial, this level of increase raises red flags. Sustaining the Fed's target of 2% year-on-year inflation requires monthly core inflation increases of at least 0.2%.

Friday afternoon saw mostly downward movement in U.S. stocks following the release of the September PCE report. The S&P 500 index was down approximately 10% from its July 31 closing high of 4,558.96 and on track to enter correction territory. To improve market sentiment, Turnquist believes that the S&P 500 needs to climb back up to the 4,200 level. He also identifies 4,050 as a crucial support level for stocks, as it was last seen in March and May. A rebound from this level would be a logical move.

In conclusion, while the market is anticipating rate cuts, the Federal Reserve remains unyielding. Volatility is expected until these two forces align. Although economic indicators show positive growth, inflation remains a concern. The stock market is experiencing a downward trend, with hopes pinned on reaching key recovery levels.

A Possible Peak for Long-Term Rates

It's still uncertain whether the 10-year yield's intraday high of 5.022% on Monday will mark the peak level for this long-term rate. According to Turnquist, until there is stability or a significant decrease in yields, it will be challenging for equities to make substantial progress.