Stock markets tumbled on Tuesday as investors slashed their bets on the Federal Reserve taking the brakes off the economy in the coming months, after hotter-than-expected inflation data led traders to expect interest rates will remain higher for longer.
The benchmark S&P 500 stock index fell over 1 percent in early trading. The index has only suffered such a large loss on one other day this year, with bullishness about the resilience of the economy and corporate profits continually pushing stocks to new highs.
Investors still expect the Fed to pull inflation back to manageable levels without inflicting too much pain on the broader economy. But that forecast was put under pressure on Tuesday by a consumer inflation report that showed prices rising more quickly than had been forecast.
The consumer data “came in stronger than either the Fed or the market wanted or expected,” said Greg Wilensky, head of U.S. fixed income at Janus Henderson Investors.
The longer inflation remains elevated, the longer the Fed is likely to push off rate cuts, turning the screws on an economy that is already starting to show some signs of weakness, and tempering enthusiasm on Wall Street.
Stuart Keiser, an equity analyst at Citi, said the inflation data was “not a game-changer” but that it was likely to drive a short-term retrenchment in the stock market as investors dial back hopes for rate cuts. “Today’s print was clearly not a good one,” he said.
At the start of this year, investors deemed it likely that the Fed would begin to lower interest rates next month, after a sustained albeit bumpy fall in inflation. Investors have now abandoned bets on a March cut, pushing out expectations beyond the Fed’s May meeting to the next one in June.
“A March cut is completely off the agenda,” said Seema Shah, chief global strategist at Principal Asset Management. “But May could still be in play if economic activity plays ball and finally starts to show the impact from prior Fed tightening.”
Investors and analysts were keen to note that one inflation report would not dash hopes for the economy averting a severe recession.
A survey of fund managers published on Tuesday by Bank of America showed optimism rising to the highest it has been since April 2022, shortly after the Fed started raising interest rates. That’s backed by the fact that investors have been funneling cash into stock markets across the globe, with allocations to U.S. stocks the highest they have been since November 2021, according to the survey.
But some investors worry that the full effect of the Fed’s rate increases is yet to be felt by the economy, raising the risk that delaying rate cuts could see the economy slip into a downturn.
The Russell 2000 index, which tracks a wide range of smaller companies closely tied to the health of the domestic economy, fell roughly 3 percent on Tuesday after notching bumper gains in recent trading sessions.
If the index sustains those losses to the end of the day, it will be its worst one-day performance of the year.