The bond market is calling the Fed’s bluff on its planned interest rate hikes next year, and that sets stocks up for gains in 2023, according to Fundstrat

• The bond market is calling the Fed’s bluff on its planned interest rate hikes for 2023, according to Fundstrat.
• That’s good news for the stock market, as a more dovish Fed would be welcomed by investors.
• “The bond market called Fed right in 2022 and now says Fed will be dovish in 2023… even if Fed doesn’t know it yet,” Fundstrat said.

The bond market is starting to call the Federal Reserve’s bluff that it will still be hiking interest rates in 2023, according to a Friday note from Fundstrat, and that’s good news for the stock market.

The note highlighted how the 2-year US Treasury yield has a knack for sniffing out where the Fed Funds Rate will most likely land going forward, as it did in January of this year when the 2-year yield yield quickly rose to about 1% while the Fed Funds rate remained near zero.

Even Jeff Gundlach of DoubleLine Capital has said the Fed could be replaced by the 2-year Treasury yield, as all the Fed does is follow what the 2-year yield does. 

Fed chairman Jerome Powell has been playing catch-up with interest rate hikes until today, as the 2-year Treasury yield is finally below the current Fed Fund’s rate.

At this week’s FOMC meeting, the Fed projected a 2023 year-end Fed Funds rate of 5.1%, suggesting three more interest rate hikes of 25 basis points next year. But the 2-year US Treasury yield has been on the decline since it peaked near 4.75% in early November, falling to about 4.25% today. 

That’s below the current Fed Funds rate of 4.38%, and it means the Fed is either going to pause its interest rate hikes from here or even cut them, according to Fundstrat.

“In 2022, the bond market called the Fed actions well ahead of the Fed. And if this carries into 2023, the bond market says the Fed will soon turn dovish. That is good news for equities,” Fundstrat’s Tom Lee said.

And the Fed has good reason to pause its interest rate hikes, according to Lee, as inflation has shown material signs of decelerating from its cycle highs, and job openings are starting to weaken. 

“It will be important for the labor market to soften and that is what is visible… LinkUp sees a 4.1% decline in JOLTS for November. This takes total job openings BELOW 10 million to 9.9 million, the lowest since early 2021,” Lee said.

“The number of new postings is the lowest since 2021. This is an unwind of 2 years of job markets, thus, it looking like wage growth should slow in 2023. This would likely further catalyze the Fed to be more dovish,” Lee explained.

This sets the stock market up for gains in 2023 because investors are “too pessimistic” and the stock market has previously seen gains during periods of economic stresses similar to today, like the late 1970’s and the early 1980’s when inflation was high and the Fed was hiking interest rates aggressively.

Additionally, corporate earnings have outpaced stock market gains since the end of 2019, suggesting there’s still upside ahead for stock prices.

“Equities are up 25% since end of 2019, [while] earnings per share is up 35%. Earnings have exceeded price appreciation over [the] past three years,” Lee said. The investment strategist expects the S&P 500 to jump 20% to 4,750 in 2023.