Why the stock market’s ‘FOMO’ rally paused and what will decide its fate

Financial market participants this past week have come closer to pricing in what the Federal Reserve has told them: the fed funds rate will peak at over 5% and will not be cut in 2023. Fed funds futures on Friday priced a peak rate of 5.17% and a year-end rate of 4.89%, noted Scott Anderson, chief economist at Bank of the West, in a note.

After Fed Chair Powell’s Feb. 1 press conference, the market was still expecting the fed funds rate to peak just below 4.9% and end the year at 4.4%. A late-breaking jobs report on Feb. 3 helped turn the tide, along with a jump in the Institute for Supply Management’s services index.

The yield of the TMUBMUSD02Y 2-year Treasury monetary policy note,
4,502%
is up 39 basis points since the Fed meeting.

“These dramatic interest rate moves at the short end of the yield curve are a big step in the right direction, the market has started to listen, but rates still have a long way to go to reflect current conditions,” Anderson wrote. “A Fed rate cut in 2023 is still a long way off, and robust economic data for January gives it even less chance.”

The surge in short-term yields was news that seemed to rock stock market investors and left the S&P 500 SPX,
+0.22%
with its worst weekly performance of 2023, while the previously sharply rising Nasdaq Composite COMP,
-0.61%
posted a streak of five weekly wins in a row.

Despite this, shares are still up significantly in 2023. Bulls are becoming more numerous but not as ubiquitous, technicians say, as a contrarian threat.

In a reflection of the market slump in 2022, previously battered tech-related stocks have rallied since the start of the new year. The tech-heavy Nasdaq Composite remains up nearly 12% for the new year, while the S&P 500 is up 6.5%. The Dow Jones Industrial Average DJIA,
+0.50%,
which outperformed its peers in 2022 is the laggard this year, up just 2.2%.

So who is buying? Individual investors have been relatively aggressive buyers since last summer, before stocks hit their October lows, while options activity has been more focused on buying calls as traders bet on the market rising rather than defending by buying puts, he said Mark Hackett, Chief of Investment Research at Nationwide, in a phone interview.

See: Yes, retail investors are back, but they only have eyes for Tesla and AI right now.

Meanwhile, analysts say institutional investors are underweight equities, particularly in technology and related sectors, relative to their benchmarks after last year’s carnage. That has created an element of “FOMO” or fear of missing out, forcing them to catch up and win the rally. Hedge funds were forced to liquidate short positions, which also contributed to gains.

“What I think is key to the next move in the market is will institutions destroy retail sentiment before retail sentiment destroys the institutional bear market?” Hackett said. “And I bet the institutions are going to look and say, ‘Hey, I’m a few hundred basis points behind [benchmark] at the moment. I have to catch up and being short in this market is just too painful.”

However, the past week contained some unwanted echoes of 2022. The Nasdaq led lower and Treasury yields rose. The yield of the 2-year note TMUBMUSD02Y,
4,502%,
which is particularly sensitive to expectations of Fed policy rose to its highest level since November.

Options traders showed signs of hedging against the possibility of a short-term spike in market volatility.

Read: Traders brace for an explosion as the cost of protection for US stocks hits the highest level since October

Meanwhile, the hot job market underscored by January’s jobs report, along with other signs of a resilient economy, are fueling fears that the Fed may have more work to do than even its officials currently anticipate.

Some economists and strategists have begun to warn of a “no landing” scenario, in which the economy sidesteps a recession or “hard landing” or even a slight slowdown or “soft landing.” While that sounds like a pleasant scenario, there are concerns that the Fed would be forced to hike rates even more than policymakers currently expect.

“Interest rates have to go up, and that’s bad for technology, bad for growth [stocks] and bad for the Nasdaq,” Torsten Slok, chief economist and partner at Apollo Global Management, told MarketWatch earlier this week.

Read: Top Wall Street economist says no-landing scenario could trigger another tech-driven sell-off in stock markets

So far, however, stocks have largely held up amid rising Treasury yields, noted Tom Essaye, founder of Sevens Report Research. That could change if the economic picture deteriorates or inflation picks up again.

Equities have largely weathered the rise in yields as strong jobs data and other updates give investors confidence the economy can handle higher interest rates, he said. That could change if the January jobs report turns out to be a mirage, or if other data deteriorates.

And while market participants have adjusted expectations more closely to those of the Fed, policymakers have not moved the goalposts, he noted. They are more hawkish than the market but no more hawkish than in January. If inflation shows signs of resurgence, then the notion that the market has priced in a “peak hawkishness” is invalidated.

Needless to say, much attention will be given to Tuesday’s release of the CPI for January. Economists polled by the Wall Street Journal expect the CPI to show a monthly increase of 0.4%, which would result in a decline in the annual rate to 6.2% from 6.5% in December after it started at 9, 1% had peaked around 40 years ago. last summer. The core rate, which excludes volatile food and energy prices, is expected to slow to 5.4% yoy from 5.7% in December.

Do not miss: Inflation data rocked the stock market in 2022: get ready for Tuesday’s CPI reading

“For stocks to remain thriving in the face of rising interest rates, we need to see: 1) the consumer price index shows no price recovery and 2) key economic data shows stability,” Essaye said. “If we achieve the opposite, we need to prepare for more volatility.”