Fed’s ‘higher for longer’ message hits US stocks and bonds

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US stocks and government bonds are on course for their worst month of the year as investors respond to the US Federal Reserve’s message that interest rates are set to stay higher for longer than previously thought.

Wall Street’s benchmark S&P 500 stock index has fallen more than 5 per cent in September — dragging it towards its first quarterly loss in 12 months. 

A retreat in the US bond market also accelerated last week after the Fed signalled it would cut rates much more slowly next year and in 2025 than investors had been pricing in.

The yield on 10-year Treasuries, which rises when prices fall, on Wednesday hit its highest level since 2007 and is on track for the biggest monthly jump in a year.

“The penny [is] dropping that actually higher for longer means higher for longer,” said Mark Dowding, chief investment officer at RBC BlueBay Fixed Income. “That realisation is the thing that’s been hurting sentiment.”

At the beginning of the month, traders in the futures market were betting that interest rates would be about 4.2 per cent by the end of 2024. Now they are betting on rates of 4.8 per cent by that time.

“The market has been consistently wrong about Fed policy this year,” said Kevin Gordon, senior investment strategist at Charles Schwab. “For a good chunk of the year the market expectation was it would be cutting aggressively this year . . . now there’s an embrace of ‘maybe [the Fed] actually means it’.”

Expectations of a prolonged period of high rates have hit equities because of the impact of higher bond yields on investors’ quest for returns, as well as the potential effect on the real economy.

The S&P is still up 11 per cent so far this year, but has been propped up by a small number of heavily-weighted tech stocks that surged earlier in the year fuelled by enthusiasm about artificial intelligence. The equal-weighted version of the index this week fell back into negative territory for the year.

Corporate debt markets have also been affected, as investors worry that highly-indebted companies may struggle to refinance their borrowings in the face of higher rates.

The average interest rate for US junk bonds has risen from 8.5 per cent to almost 9 per cent this month, outpacing the rise in Treasury yields.

The shift in the US has come as the Fed reacts to strong economic data and a still hot labour market, which contrast with the eurozone and the UK, where fears of a downturn — which would reduce pressure to keep interest rates high to control inflation — are greater.

“It’s like the market is finally getting on board with the view that we’re not on the brink of a recession,” said Sonal Desai, chief investment officer at Franklin Templeton Fixed Income.

Fed officials last week lowered their forecasts for unemployment and increased their growth predictions. 

While the central bank held its main interest rate steady in a range of 5.25 to 5.5 per cent, projections by its policymakers signalled one more increase this year.

Soaring oil prices compounded market worries about persistent inflation and tight monetary policy.

Brent crude jumped nearly 3 per cent on Wednesday to a 10-month high of more than $97 a barrel, as lower than expected US stockpiles added to fears of a global supply shortfall.

Some investors predict that higher rates could eventually push the economy towards recession despite the recent strong data.

“One of our concerns is that the lagged effect of Fed tightening will catch up with the economy as we move into 2024,” said Jeff Schulze, head of economic and market strategy at ClearBridge Investments. “The longer rates are up there, the higher the chance.”