The Fed, as we said, has been quite consistent in its messaging. While inflation appears to have peaked, it remains well above the central bank’s 2% target. (As expected, there are now many commentators who argue that the 2% target should not be followed.) As such, there is still tightening to be done (see Chart 1). The fear is that inflation has become stickier, and that a further decline from hereon will be harder — and slower.
"Don’t fight the Fed.” This mantra has been the holy grail that has served market investors well for years, that is, until recently. US stocks rallied strongly at the start of 2023, even as the Federal Reserve continues to hike interest rates. Investors are betting that inflation has peaked, and that the Fed will pivot to cutting interest rates in 2H2023 — never mind that Fed officials have consistently pushed back against this view.
Notably, the technology-heavy Nasdaq Composite is up 16.6%, almost double the 8.9% gain for the broader Standard & Poor’s 500 index and well above the 2.7% increase for the Dow Jones Industrial Average (at the time of writing). This relative performance would be rational — and the correct strategy for investors — IF interest rates do start falling, as the market expects. Cash flows of high-growth, tech stocks are typically farther into the future. Thus, their valuations would see the biggest boost in a falling interest rate environment. The question, though, is this: Are interest rates going to fall in the coming months? The answer is key to determining whether this rally is sustainable or a false dawn.
