The Market is Disregarding Fed Rates

The Wall Street adage advises to “never fight the Fed,” but traders are defying this wisdom, potentially igniting a rally in overlooked segments of the stock market.

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Federal Reserve forecasts and statements from central bankers have made it clear that interest rates will remain elevated longer than previously anticipated, with Fed officials projecting only one rate cut this year.

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Nevertheless, investors are flocking to stocks that benefit from lower borrowing costs. The technology sector saw $2.1 billion in inflows this week, the highest since March, according to EPFR Global and Bank of America data.

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“The market remains unconvinced that inflation and labor market indicators will restrict the Fed’s ability to implement multiple cuts this year,” said Keith Buchanan, senior portfolio manager at GLOBALT Investments. “This stubbornness maintains an environment favorable to risk assets.”

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Despite the Fed’s forecasts for fewer rate cuts and Fed Chair Jerome Powell’s hawkish comments at his recent press conference, the S&P 500 Index surpassed 5,400 for the first time ever on Wednesday, a level it maintained through at least Friday. The benchmark has surged over 50% since bottoming out in October 2022 during a bear market prompted by the Fed’s aggressive rate hikes starting in March 2022 to curb runaway inflation.

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Investors now face the question of how the market will respond when the Fed eventually cuts rates.

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Historically, rate cuts have been pivotal in driving strong equity returns, particularly in cycles not triggered by recessions. This context explains the recent rotation into financials, materials, and utilities—three key sectors closely linked to the economy and typically benefiting from rate cuts amid robust economic growth.

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Consensus expectations suggest continued economic growth, with the Atlanta Fed’s GDPNow model projecting second-quarter real GDP growth at a 3.1% annual rate, up from 1.3% in the first quarter.

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“There are few signs of an imminent severe economic downturn,” said Carol Schleif, chief investment officer at BMO Family Office.

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Tech Stocks Surge

Fund managers are also increasing their exposure to tech stocks. The Nasdaq 100 Index has gained 17% in 2024. Shares of the seven largest companies in the S&P 500 are trading at an average of 36 times projected profits, compared to a multiple of 22 for the overall benchmark, according to Bloomberg data.

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Overall equity positioning has reached its highest level since November 2021, when the Nasdaq 100 was at its peak, according to Deutsche Bank AG data for the week ending June 14.

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Both rules-based and discretionary investors, who use predefined guidelines and algorithms for decision-making, contributed to this week’s increase, with significant positioning shifts in tech as well as rate-sensitive sectors like utilities, staples, and real estate.

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If the Fed adopts a decidedly dovish stance, defensive market segments that pay steady dividends, such as consumer staples and real estate, could become more attractive, noted Terry Sandven, chief equity strategist at US Bank Wealth Management.

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Upcoming Market Volatility

June typically marks a quieter period for markets with lower trading volumes as summer approaches. However, next week brings a potential disruption: “triple witching.” This event, where contracts tied to stocks and indexes expire on Friday, coincides with the quarterly rebalancing of indexes, usually leading to a spike in volatility and trading volumes.

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“Next week could be quite eventful for equities,” said Frank Monkam, senior portfolio manager at Antimo.

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In summary, while the Fed signals higher rates for longer, traders are betting on sectors benefiting from lower borrowing costs, leading to significant inflows into technology stocks and other rate-sensitive groups. Historical patterns suggest potential strong equity returns once rate cuts begin, especially if economic growth remains robust. However, upcoming events like “triple witching” could introduce short-term volatility in the market.

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