- The S&P 500 has rebounded 17% from its June lows, with investors feeling strangely cheery.
- The rally has been driven by signs that inflation is cooling and that the Federal Reserve won't hike rates as hard.
Like a basketball hitting a trampoline, the S&P 500 has bounced higher after plummeting in the first half of the year. As of early Friday, the benchmark US stock index was up 17% from its June low.
Elsewhere in the market, things are looking even brighter. The NYSE FANG+ stock index — which tracks 10 leading Big Tech players — is technically back in a bull market, with the likes of Amazon and Tesla having soared more than 20%.
But Americans, and other people around the world, are highly gloomy about the prospects for their economy. Inflation in advanced economies is running at its hottest for many decades, and central banks look dead set on bringing it back under control, no matter what the cost.
So why are stock market investors so cheerful? Two charts explain why. But another one suggests an economic crunch could bring any rally to an end.
At the heart of recent investor optimism is the fact that inflation looks like it could finally be cooling, as the US and global economies slow.
Oil prices have dropped around 20% from their recent highs, US gasoline prices are below $4 a gallon after topping $5 in June, and commodities are down sharply. The year-on-year US inflation rate finally fell in July, another reason to for hope.
With inflation falling and worries about a recession rising, the Federal Reserve will now no longer need to hike interest rates as high, and will even start cutting them next year. Or so the optimistic story goes.
Investors have quickly reassessed the path of Fed interest rate rises. In June, markets were predicting the US central bank would hike as high as 4%. That's according to prices for Fed funds futures, which are derivatives that track rate expectations.
But signs of weakness in the economy and ebbing inflation prompted traders to rethink in July. By the end of that month, they were expecting rates to peak at 3.3% in December before falling to 2.6% by January 2024, according to Bloomberg data.
Since then, as the chart above shows, there's been a reassessment in the other direction as Fed officials have pushed back against the narrative. Yet traders are still expecting rate cuts.
Longer-term bond yields, which are sensitive to interest-rate expectations, have fallen sharply from their June highs. That's boosted tech stocks in particular, which tend to thrive when borrowing costs are lower.
Despite the rally, almost all analysts are warning that investors should be careful. Many believe there's no basis for the market's confidence that the Fed will cut rates again and avoid a damaging recession.
Wells Fargo's team has said its likely a recession is coming. Its analysts' favorite indicator is flashing a bright red signal right now, they said this week.
The yield on the 10-year US Treasury note is now well below the yield on the 1-year Treasury bill, Wells Fargo said.
That's an inversion of what should normally happen, and suggests that economic growth is going to be much lower in the future — which would require the Fed to slash rates hard.
When was the last time the 10-year yield was this far below the 1-year? In 2007 — when the financial crisis took hold.
If a tough recession hits soon, companies' earnings are likely to get crushed. And any rally in stocks would almost certainly be over.