Markets are signaling the Fed is being too aggressive in fighting inflation - and a 100 basis point hike this month isn't important to stock prices

Markets think the Fed is overestimating what it'll take to bring down inflation, according to DataTrek.
In a telling sign, stocks did not make fresh lows when talk of a 100 basis point hike began last week.
That is because the size of the hikes is less relevant than where the Fed Funds rate ultimately ends up.

The market is sending signals that the Federal Reserve is overestimating what it will take to bring down inflation, and that it isn't the size of the rate hikes but their ultimate end point that matters most to stocks, according to a note from DataTrek on Monday.

While many pundits have urged the Fed stamp out high inflation by any means at its disposal — including hiking rates by a whopping 100 basis points this month — DataTrek Research co-founder Nicholas Colas said that size and pace of increases isn't as important as the level they will ultimately raise rates to, suggesting that steep and immediate rate hikes aren't necessarily the answer.

"The chatter around a 100 bp hike after last Wednesday's hot CPI inflation print did not take US large caps to fresh lows because the pace of Fed hikes is not as important as where markets believe Fed Funds will average over the next 24 months," Colas wrote.

The 2-year Treasury yield, an indicator of market expectations in the short-term, is correlated to the average Federal Funds rate over the next two years, making a sharp 100-point hike some have predicted less relevant in the long-run. And, importantly, the 2-year rate of 3.13% is not far from the projected average of 3.53% the Fed projected last month, the DataTrek note points out.

"That signals that the market believes the Fed is overestimating how much monetary policy tightening will be required to reduce inflation," Colas said.

The good news is that the Fed may pick up on these signals from the market, and pull back a bit on its expected path of tighter policy.

"[F]or the first time since 2020, markets think the Fed's projected path is too aggressive. This could leave room for Chair Powell and the FOMC to start guiding down longer-run rate expectations if inflation does start coming down quickly."

Some Fed officials last week signaled their support for a 75 basis point rate hike at this month's meeting of the Federal Open Market Committee, with Fed Governor Christopher Waller saying the central bank wanted to avoid a "knee jerk" reaction to last week's tough inflation report.

There is also some encouraging data for the Fed to look at when it meets next week. The University of Michigan Consumer Sentiment Survey rose by by 1.1 points last week from June's record-low, and the 5-year, 5-forward rate, an expectation for 5-year inflation 5 years from now, is relatively stable, which could mean less tightening is ahead for the central bank than previously expected.

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