Trading Desk: How Wall Street Learned To Love The Fed

The S&P 500 is up 4.6% since the month started and more speculative technology and growth-oriented stocks are rallying even harder. If you think it’s because Wall Street is betting that the Fed will blink, you’re wrong.

Interest rate expectations have gotten steeper in the last three weeks, with most futures traders now anticipating that the Fed will hike an extra 25 basis points (0.25 percentage point) over the coming year than they did back in June.

As pernicious and persistent as inflation has been, it’s hard to argue with them. The Fed has already raised overnight rates about 162 basis points from zero in the last few months without much impact on price pressure. The big guns clearly need to come out.

And at a certain point, non-zero rates were seen as bad for stocks, triggering the recent bear market that started on the high-multiple growth end of the market and working its way across to the safe havens. Now, however, higher expectations aren’t getting in the way of the rebound.

The logic is actually fairly simple. For one thing, we measure stock valuations against long-term interest rates, not the ultra-short-term end of the yield curve where the Fed is in control. Ironically, high inflation is a factor here.

Say you want to at least have a chance of keeping up with 9% inflation. You can’t do it with Treasury bonds, which pay about 3% a year even on the long end of the curve. You need to take on a little risk and find companies that are growing fast enough to cover the spread.

Burton Malkiel, king of the random walk theory, once calculated that for stocks to even have a reasonable shot at a 9% return over time, they need some combination of dividends and growth that adds up to 9%.

With dividends on the S&P 500 barely coming in at 1.5%, that means reaching for 7.5% long-term growth. A lot of companies have that and so does the S&P 500 as a whole. It looks achievable.

Short-term Treasury rates just can’t compete with that until the Fed manages to wrestle inflation down. And even on the long end, there are signs that 10-year yields are having trouble pushing much beyond 3%.

When the year started, that yield was only half where it is today, but that’s enough to take a lot of air out of a lot of stocks. Now, however, that long yield just isn’t going anywhere fast.

That’s a challenge for the Fed, which wants to keep the yield curve coherent and manage recession fears. But it isn’t a challenge for stock investors who want a shot at beating inflation.

Whether short-term rates climb to 3.5% or 3.75% in the coming year, it doesn’t really factor much into the math. The big percentage moves are already behind us. Maybe long yields will climb another 1.5% or 1.75% to compensate. Valuations won’t feel that much added strain.

And of course, higher rates will be a boon to the weakest side of the market, the financials. We could use some cheer in that sector. The Fed will do it.

[class^="wpforms-"]
[class^="wpforms-"]