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Investors are placing a big anti-inflation bet on stocks this year that may not pan out, according to Wolfe Research. The S & P 500 is up close to 5% year to date , a move coming as markets look forward to the end of the Federal Reserve’s interest rate hikes, which were implemented to control inflation. With market pricing indicating that the Fed is likely to raise its benchmark borrowing rate by just another half a percentage point or more, investors have grown more comfortable with owning stocks. Fed fund futures are even anticipating some mild rate cuts by the end of 2023, according to CME Group data. Analysts at Wolfe say that could be a mistake as Fed Chair Jerome Powell and other policymakers have vowed to be vigilant until they are convinced inflation is coming down. “We also believe that the market is vastly underestimating the Fed Chair’s desire to avoid a 1970’s-style inflation resurgence,” the firm said in a client note. “We expect Powell to disappoint markets by maintaining a hawkish tone during his press conference on February 1st.” The 1970s saw the central bank raise rates to control inflation, only to cut them on signs of economic weakness. That led to more draconian increases in the early 1980s that sent the economy into a double-dip recession. Multiple Fed officials have vowed not to repeat those mistakes. Markets are assigning essentially a 100% probability to the Fed raising its funds rate 0.25 percentage point at the Jan. 31-Feb. 1 meeting of the Federal Open Market Committee. Futures pricing indicates another quarter-point hike in March before the Fed pauses to assess the impact that rate increases have had on inflation and the broader economy, particularly the labor market. That second quarter-point increase would lift the funds rate to a target range of 4.75%-5%, the highest level since October 2007. An aggressive round of tightening in 2022 coincided with the S & P 500 falling nearly 20% . Fed rate hikes work by essentially tightening financial conditions, of which stock prices are a key component. So a rising market is indicative of investors seeing an easier Fed on the way. Prices are rising despite widespread anticipation that the economy will fall into recession at some point this year. “We largely attribute the recent sharp ‘risk on’ rally to the market looking through near-term economic weakness and toward the next Fed cutting cycle — even though the current hiking cycle isn’t over yet!” the Wolfe team wrote. While several Fed officials in recent days have confirmed that they expect the level of rate hikes to get smaller , they also said they don’t expect any rate cuts at least through 2023. “For U.S. markets, 2023’s fresh take is that the American economy can avoid a deep recession because inflation is declining quickly, allowing the Fed to soon end its rate hike cycle and even entertain rate cuts later in the year,” DataTrek Research co-founder Nicholas Colas said in his Monday evening note. “Counterpoint: history also shows that the Fed most often cuts policy rates during recessions … and very little about the U.S. economy says ‘recession’ right now.” Markets will get a better look at the economy Thursday when the fourth-quarter gross domestic product data is released. The central bank also will see one more key data point before its next meeting, the personal consumption expenditures price indexes, which will be released Friday. Core PCE is the Fed’s preferred inflation measure. — CNBC’s Michael Bloom contributed to this report.
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