By David Randall and Lewis Krauskopf
NEW YORK (Reuters) - Soft landing hopes that have powered U.S. stocks this year received a boost following encouraging inflation data and a nod from the Federal Reserve at progress made in fighting consumer prices.
Expectations for a so-called soft landing, in which the Fed is able to tame inflation and eventually cut interest rates while growth remains resilient, have been a key factor in the S&P 500's march to record highs in 2024.
A string of higher than expected inflation prints challenged that narrative earlier this year. Wednesday’s data, however, showed U.S. consumer prices unexpectedly unchanged in May, potentially opening the door for the Fed to cut rates later this year.
Later in the day, Fed Chairman Jerome Powell noted in a press conference at the end of the central bank's policy meeting that inflation had fallen without a major blow to the economy, and said there was no reason to think that trend can't continue.
Powell also reiterated policymakers would need to see further evidence that prices were cooling before cutting rates. Fed officials, meanwhile, reined in projections for how aggressively they would cut rates this year, from three 25 basis point rate cuts to just one - a shift that was largely expected by investors.
"The Fed is saying that the last mile to get to 2% inflation will be longer, but the market still believes in a decent growth and labor outlook that will gravitate toward a soft landing," said Saurabh Sud, a portfolio manager at T. Rowe Price. "The Fed is coming around to the view that there are no big slowdown concerns coming."
The S&P 500 closed the day up 0.9% at a fresh record and is up nearly 14% this year. The 10-year Treasury yield, which moves inversely to bond prices, hit its lowest level since April first but subsequently regained some of those declines.
The soft landing narrative has been an important one for markets in recent months.
Investors started the year pricing in more than 150 basis points of rate cuts but quickly rolled back those bets when it became evident that the economy was too strong for the Fed to ease monetary policy without risking an inflationary rebound.
Futures markets late Wednesday were pricing in 45 basis points of easing, a more aggressive view than the Fed projected.
"The market definitely took the soft landing point of view (on Wednesday)... but the Fed is saying we need more time," said Matthew Miskin, co-chief investment strategist at John Hancock Investment Management. "What the market really wanted was rate cuts this year, and I think the market is going to have to be patient on it."
Still, growth has remained resilient and corporate earnings have beaten expectations, supporting the view that the economy was enduring elevated rates for the time being and stoking investor optimism.
Carol Schleif, chief investment officer at the BMO (TSX:BMO) Family Office, said she was sticking with her view of a strong economy to remain through year end, following the better-than-expected CPI data and the lack of major surprises from the Fed meeting.
"When the Fed does start to cut ... you're still going to have an economy underneath that's doing pretty well," Schleif said. Her firm is recommending a moderate overweight to stocks, with a bias toward U.S. equities.
Signs that inflation is continuing to fall and the Fed is on pace to eventually ease policy could continue steering Treasury yields lower, raising the allure of stocks for investors in comparison with fixed income and lowering borrowing costs.
They could also help sectors of the market that have been dented by higher rates, including shares of small caps and financial companies, investors said. The small-cap focused Russell 2000, for instance, is only up around 1.5% this year despite a sharp rally on Wednesday, lagging far behind the S&P 500.
Still, there remains the risk that the Fed will delay cutting rates too long and potentially hurt growth, said Don Ellenberger, senior portfolio manager at Federated Hermes, who expects rates to move "sideways" for the remainder of the year.
"The Fed is getting the data that it wants to see but at the same time they're between a rock and a hard place," he said. "It really wants to cut rates but they don’t have enough data and they are afraid that the longer they keep the Fed funds rate above 5% the greater the chance something breaks."