On Wednesday, the Federal Reserve continued efforts to tame inflation by raising interest rates for the fourth consecutive time — and communicating that more hikes are on the way.
Stocks rallied in the aftermath, with the S&P 500 jumping 2.6% on Wednesday and another 1.2% on Thursday.
The rip higher has extended the roughly six-week reversal in what has been an ugly 2022 for stocks to date; through Thursday's close, the S&P 500 has bounced back roughly 11% from its lows in mid-June.
The Fed usually shrugs off moves in the stock market, but the turn in equities has also coincided with an alarming turn in bond markets as well — which could brew trouble for policymakers.
Longer-term interest rates, which the Fed does not directly control, don’t appear to be getting Fed Chairman Jerome Powell’s message on further rate increases. And that could potentially dampen the intended impact of raising interest rates, which is to help slow demand to slow inflation.
“We worry that some in markets may be seeing the pivot they want to see, as opposed to a transition from one phase of policy to another that is naturally more data-dependent,” Evercore ISI analysts wrote on Thursday.
Since the Fed’s June 15 meeting, the yield on the 10-year U.S. Treasury has fallen by over 0.70%, to just below 2.70% as of Thursday afternoon. As a benchmark for interest rate products, the decline could make longer-dated credit products (i.e. business loans) less expensive than they were a month ago.
Mortgage rates, often the largest longer-dated debt for households, have similarly declined since mid-June. The average 30-year fixed rate mortgage rate has dropped 0.5% over the last five weeks, standing at 5.3% as of Thursday.
The combination of higher stock prices and lower longer-term borrowing costs makes for easier financial conditions, potentially steady demand and complicating the Fed’s efforts to lower inflation.
“[T]he substantial easing of financial conditions that occurred in response to [Wednesday's] meeting will ultimately be an unwelcome development for the Fed as it seeks to achieve price stability,” Deutsche Bank analysts noted on Thursday morning.
For his part, Powell said Wednesday that financial conditions remain tight compared to earlier in the year, adding that the impact of broadly higher longer-term rates "should continue to temper growth and help bring demand into better balance with supply."
That is, unless conditions cease tightening further.
'We don't control that second step'
Fed policy works its way through the financial system in two steps: the first is short-term rates, which the Fed controls; the second is longer-term rates, which are set by markets but influenced by where short rates are set.
The central bank began raising interest rates in March of this year, pushing up the rates used by banks to borrow from one another on an overnight basis.
But the second part of this transmission tightens broader financial conditions, as longer-term rates, which impact business and consumer borrowing, are pushed higher by markets.
Until, of course, investors begin to doubt the Fed's ability or desire to further raise rates and investors price in an economic slowdown, future interest rate cuts, or both.
“We don’t control that second step,” Fed Chairman Jerome Powell said Wednesday in response to a question from Yahoo Finance. “We’re just going to do what we think needs to be done.”
Up until a month and a half ago, markets appeared to get the message. The yield on the U.S. 10-year more than doubled over the first half of the year — from around 1.5% in January to a high of 3.43% in mid-June — as the hiking campaign began.
But a reversal in recent weeks, despite the Fed’s insistence this week that it will continue to raise rates, signals expectations that a recession will back the Fed into rate cuts as soon as next year.
The Fed’s read on the matter is that bond markets are pricing in the expectation that inflation will decline, which Powell said is a “good thing.”
For now, Powell has only promised more interest rate hikes, with little detail on the size and pace of those coming moves. Powell articulated Wednesday that at some point, the Fed could back off of its large rate hikes, but said additional “unusually large” moves, like the 0.75% enacted over the last two meetings, remain on the table, depending on the data.
If financial conditions don’t look tight enough, the Fed chief suggested they will communicate that to markets.
“Of course, we'll be watching financial conditions to see that they are appropriately tight, and that they're having the effect that we would hope they're having,” Powell said Wednesday.
Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.