Wall Street Backs Off Bets on Fed Rate Cuts; Economy's resilience has consistently surprised investors

Persistent strength in the economy has wrong-footed bets that the Federal Reserve will make large interest-rate cuts this year, potentially undermining a key element of support for the 2023 stock rally .

Derivatives markets show investors now expect the Fed's target rate to sit at 5% at year-end, according to Tradeweb, up from just above 4% last month.

Previous expectations that rates would fall before December helped boost markets this year, particularly shares of large technology companies . Apple, Amazon.com and Facebook parent Meta Platforms—battered in 2022 as rates rose—have all climbed more than 35% so far this year. The Nasdaq Composite has gained 28%.

Some say a second half featuring higher interest rates would likely drag on stocks, despite persistent strength in the economy and corporate profits . Many note that most U.S. stock sectors have been weak this year even as major indexes rise.

"The Nasdaq has been up sharply because it has been led by just a few names, but most groups of stocks outside of that have been down," said Rhys Williams, a portfolio manager at Spouting Rock Asset Management. "That really reflects how nervous people are about what it might mean to have no interest-rate cuts coming."

Friday's jobs report was just the latest setback for investors who have repeatedly underestimated U.S. growth in the face of rate increases. Inflation has also proved far more stubborn than investors had guessed it would be 12 months ago. Last summer, year-ahead inflation bets projected a rapid fall to the 2% inflation range beginning in the middle of 2023. The latest reading of the consumer-price index was 4.9%.

A tight labor market means the Fed might skip raising interest rates this month but consider another rate increase at its next meeting this summer, said Rich Steinberg, chief market strategist at the Colony Group.

"The narrative is going to be, let's wait to see what happens and then be data-dependent again in July," he said.

The disappearance of bets on rate cuts has driven up short-term Treasury yields, which closely follow investors' expectations for Fed policy. The two-year yield ended Friday at 4.501%, up from 4.064% at the end of April. But the climb hasn't rattled other markets. Last year, rising yields slammed stocks, sending the S&P 500 down nearly 20%. Friday, the S&P finished the day up more than 1% on a day yields also rose.

That pattern—in which stocks have benefited from expectations of Fed rate cuts and from signs the economy will remain strong—has made it especially challenging to forecast the market's path going forward, investors said.

Ellen Zentner, chief U.S. economist for Morgan Stanley, is sticking to her call that the Fed will leave interest rates unchanged at its June meeting and stay on pause for the rest of the year. Zentner then expects the Fed to begin cutting rates in the first quarter of 2024.

Some investors have shown confidence that a recession will be avoided. Fixed-income traders continue to buy junk bonds , demanding yields only 4 to 5 percentage points more than Treasurys in a sign many believe that defaults by low-rated companies will remain rare. During past recessions, investors have often demanded yields more than 8 percentage points greater than Treasury yields as compensation for their heightened risk.

Despite the possibility of a recession, the possibility of significant gains if the economy avoids a downturn has drawn many investors to continue bidding for risk assets, said John Gregory, a Wells Fargo managing director who leads sales of junk bonds and loans.

"There's enough positive economic data out there that people still believe you could have a soft landing," Gregory said. "If that's the case, investors feel that they need to be invested—but the downside risk is that the recession becomes more severe than anticipated."