Recent unexpectedly strong economic data have caused U.S. investors to reassess their outlook on U.S. monetary policy. After February’s Federal Open Market Committee (FOMC) meeting, federal funds futures were pricing in a terminal rate of 4.9% and a year-end rate of 4.4%, implying two rate cuts by the end of 2023. However, continued labor market momentum, surging retail sales and strong CPI and PCE prints released in February suggest that the economy and inflation may prove more resilient than initially anticipated. Markets are now more hawkish, pricing in a terminal rate of 5.4% and no cuts until 2024. This implies three hikes with the possibility of a fourth at the July meeting. Notably, persistent inflation fears have materialized in Europe as well, and markets now expect the European Central Bank to hike to a terminal rate of 3.9%.
In February, markets suffered as investors grappled with the prospect of higher rates for longer. The S&P 500 fell 2.6%, while the 2-year Treasury yield recently climbed to a cycle high of 4.9% and the 10-year yield breached 4%. Looking ahead, we remain cautious toward equities. Although valuations have improved after February’s sell-off, the S&P’s forward P/E ratio remains slightly above average levels, indicating that equities may come under further pressure due to higher rates. However, despite the recent back up in yields, we expect the economy will eventually slow, inflation will fall and monetary policy will become looser.