The U.S. stock market rallied sharply in January and into early February, with the S&P 500 Index registering a year-to-date total return of 9% through February 2. The rally was driven by a series of encouraging reports about the health of the U.S. economy, alongside positive developments abroad—including the reopening of the Chinese economy and falling energy prices in Europe.

The two most notable positives for the U.S. came from:

1. Employment: where new jobs reported rose to 517,000 in January after marching steadily lower over the previous five months.
2. Consumer spending: where credit card spending increased sharply after dipping to concerning levels in the latter part of 2022.

These positive developments, combined with the ongoing decrease in inflation, meant that many investors began to believe that both a U.S. and global recession could be avoided.

Rates Higher for Longer 

Unfortunately, a more somber outlook took hold in the middle of February as investors began to recognize that these positive developments were likely to lead to a more hawkish Fed—as evidenced by the 10-year U.S. Treasury yield rising from 3.39% on February 2 to 3.96% by February 21. 

This happened because futures markets shifted their predictions for the path of the federal funds rate notably higher. In the beginning of February, futures markets projected the fed funds rate to peak at 4.89%. But by February 21, that projection had shifted to a peak of 5.37%. More notably, the futures market also raised its expectation for rates over the long run from 2.87% to 3.63%.

Because Inflation is Not Falling Fast Enough 

So why would the market expect the Fed to be more hawkish, given that the recent CPI report confirmed that inflation is falling? It’s because the portion of inflation that the Fed is most worried about falls into the category of “services excluding shelter.” And, unfortunately, this portion of inflation has not yet shown signs of falling—and it also happens to be the portion of inflation that is most sensitive to wages. 

The Fed recognizes that, while strong employment and consumer data are a signal that the U.S. economy is on healthy footing, they are also a signal that wage inflation is likely to remain stubbornly high. This means that the Fed probably needs to tighten policy even further in order to get wage inflation under control.

The bottom line is that the Fed is stuck between a rock and a hard place. They want the economy to avoid recession, but they also know that they need to weaken the labor market in order to get inflation under control.

Conclusion 

In conclusion, while there certainly are reasons to be optimistic about the near-term path of the U.S. economy, these encouraging signs may be short-lived because they could force the Fed into a more hawkish stance.

As a result, we remain cautious about the medium-term path for the U.S. economy. At least for now, any positive economic news could ultimately just mean a recession is delayed rather than avoided. So, despite a somewhat rosy near-term outlook, T. Rowe Price’s Asset Allocation Committee is maintaining an underweight position in stocks relative to bonds.