Stock markets fell Tuesday as investors cut their bets the Federal Reserve would rein in the economy in coming months, after hotter-than-expected inflation data led traders to expect interest rates to remain higher for a longer period.
The benchmark S&P 500 stock index fell more than 1% in morning trading. The index has suffered a loss this big on only one other day this year, with bullish sentiment on the economy’s resilience and corporate profits continually pushing stocks to new highs.
Investors still expect the Fed to bring inflation back to manageable levels without inflicting too much pain on the broader economy. But that forecast came under pressure Tuesday by a report on consumer inflation that showed prices had risen faster than expected.
The consumer data “came in stronger than the Fed or the market wanted or expected,” said Greg Wilensky, head of U.S. fixed income at Janus Henderson Investors.
The longer inflation remains high, the longer the Fed is likely to forego rate cuts, turning the screws on an economy that is already starting to show some signs of weakness and tempering enthusiasm on Wall Street .
The two-year Treasury yield, which is sensitive to changes in investors’ interest rate expectations, rose a tenth of a percentage point, to about 4.6%, a big move in that market.
As market interest rates have risen, the value of the dollar has also risen, putting pressure on currencies around the world, with the Japanese yen nearing its weakest levels since November.
In unstable market conditions, some companies decided to suspend sales of new debt, preferring to wait until the market stabilized.
Stuart Kaiser, an equity analyst at Citi, said the inflation data is “not a game changer” but will likely lead to a near-term pullback in the stock market as investors reduce hopes for rate cuts. “The press today was clearly not good,” he said.
Earlier this year, investors thought it highly likely that the Fed would begin lowering interest rates next month after a sustained, if uneven, decline in inflation. Investors have now abandoned bets on a March cut, shifting expectations beyond the May Fed meeting to the next one in June.
“A cut in March is completely off the agenda,” said Seema Shah, global chief strategist at Principal Asset Management. “But the month of May could still be in play if economic activity makes its contribution and finally starts to show the impact of the Fed’s previous tightening.”
Investors and analysts were keen to stress that a single inflation report would not dash hopes that the economy will avoid a severe recession.
A Bank of America survey of fund managers released Tuesday showed optimism rose to its highest level since April 2022, shortly after the Fed began raising interest rates. This is supported by the fact that investors have been funneling liquidity into stock markets around the world, with allocations to US stocks at the highest levels since November 2021, the survey found.
But some investors worry that the full effect of the Fed’s rate hikes has yet to be felt by the economy, raising the risk that delaying rate cuts could lead to the economy slipping into a recession.
The Russell 2000 index, which tracks a broad range of smaller companies closely tied to the health of the nation’s economy, fell more than 3% on Tuesday after posting exceptional gains in recent trading sessions.
If the index were to sustain such losses until the end of the day, it would be its worst daily performance since September 2022.