Markets bet the economy can withstand higher rates

The Federal Reserve will have to raise rates more to cool down inflation. But economic activity and corporate earnings are robust enough to hold up anyway.

• That, at least, is what futures markets have priced in over the last couple of weeks.

The intrigue: Bond yields have moved up sharply this month, reflecting expectations the Fed will crank rates higher than previously thought. In that same time frame, prices for stocks and other risky assets have been roughly flat.

• It's a contrast to last year, when there was a close relationship between the prospect of tighter money and a stock market selloff.

Why it matters: Markets are betting that the economy will remain resilient even in the face of further rate increases, while last year, there was more of a sense that tightening would necessarily trigger a recession.

Where it stands: The moves in the bond market this month have been swift, reflecting the possibility that the Fed will have to hike ever higher to cool the economy. The market, for instance, is no longer fully pricing in that the Fed will slash rates this year.

• It comes on the heels of a blockbuster jobs report two weeks ago and too-hot-for-comfort reports on both consumer and producer prices and retail sales this week.
• Yesterday, two Fed officials — Cleveland Fed president Loretta Mester and the St. Louis Fed's Jim Bullard — suggested they may have preferred to raise rates half a percentage point at the policy meeting Feb. 1, not the quarter-point that the committee embraced.

By the numbers: Take a look at the yield on the U.S. two-year Treasury securities, which is most sensitive to monetary policy shifts. On Feb. 1, the two-year borrowing rate was 4.19%. As of this morning, it was 4.68%.

• By contrast, the S&P 500 over that same time frame is essentially flat — down 0.7%, as of yesterday's close.

Between the lines: This is a reversal of a pattern that prevailed from roughly November through January, when markets started pricing in Fed cuts in 2023, essentially assuming inflation will come down on its own.

• The current pattern — markets accepting that there will be higher rates for longer, yet financial conditions not really tightening as a result — raises questions about the effectiveness of the Fed's tools in fighting inflation.
• If financial markets and consumer spending remain buoyant in the face of higher rates, it raises the prospect of a harder path to bringing inflation down than has become the mainstream view.

What they're saying: "An economy that grows quickly is not inherently problematic, but elevated inflation, caused by unanchored inflation expectations, could arise if growth continues," said Tuan Nguyen, U.S. economist at RSM, in a note.

• "The so-called no-landing scenario, in which the economy continues to grow and avoids a contraction, is not a situation that the Fed is willing to bet on," Nguyen wrote.