Stocks sink as persistent inflation resets Fed rate forecasts

Stock markets tumbled on Tuesday as investors scaled back bets on the Federal Reserve slowing the economy in coming months, after better-than-expected inflation data led traders to expect interest rates to stay higher for longer.

The benchmark stock index S&P 500 fell more than 1 percent in early trading. The index has suffered such a big loss only once this year, as optimism about the economy's resilience and corporate earnings continued to push stocks to new highs.

Investors still expect the Fed to bring inflation back to manageable levels without hurting the broader economy too much. But that forecast was challenged on Tuesday by a consumer inflation report, which showed prices rising faster than forecast.

Consumer data “came in stronger than 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 high, the longer the Fed is likely to delay rate cuts, tightening an economy that is already showing some signs of weakness and dampening enthusiasm on Wall Street.

Stuart Keiser, an equity analyst at Citi, said the inflation figures were “not a game-changer” but were likely to lead to a near-term cut in the stock market as investors scale back hopes for rate cuts. “Today's print was clearly not good,” he said.

Early this year, investors thought it likely that the Fed would start cutting rates next month after a sustained, if bumpy, decline in inflation. Investors have now abandoned bets on a March rate cut, pushing expectations after the May Fed meeting to the next one in June.

“A cutback in March is completely off the agenda,” said Seema Shah, chief strategist at Principal Asset Management. “But May could still have a role to play if economic activity kicks in and finally starts to show the impact of previous Fed tightening.”

Investors and analysts were keen to note that one inflation report would not dash hopes that the economy could avert a serious recession.

A survey of fund managers released Tuesday by Bank of America showed optimism rose to the highest level since April 2022, shortly after the Fed began raising rates. That's supported by the fact that investors have been funneling cash into stock markets around the world, with allocations to US stocks at their highest since November 2021, according to the survey.

But some investors worry that the full effect of the Fed's rate hikes may not yet be felt by the economy, raising the risk that delaying rate cuts could send the economy 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 about 3 percent on Tuesday after posting huge gains in recent trading sessions.

If the index sustains these losses until the end of the day, this will be the worst single-day performance of the year.