A Trifecta Of Developments Has Flipped Markets Upside Down This Week

Investors' expectations for rate cuts were flipped on their head this week after encouraging economic data and dovish commentary from a top Fed official.

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• The market did a 180 this week, with last week's sell-off in stocks and bonds giving way to a sharp rally.
• The rebound was fueled by a trifecta of events that renewed the outlook for Fed rate cuts.
• Investors see higher odds of two rate cuts this year, after fearing no cuts or even another hike.

Stocks and bonds staged a major turnaround this week thanks to a perfect storm of factors that have bolstered traders' expectations for rate cuts in the coming year.

The S&P 500 rose sharply over the week, heading for a gain of about 3%. That puts the benchmark index on track for its best weekly performance since Donald Trump's election win in November.

The Nasdaq was headed for a gain of more than 2%, while the Dow Jones Industrial Average was looking to lock in a gain of more than 3.5% for the week.

Bonds also rallied, with the yield on the 10-year US Treasury sliding more than 20 basis points since Monday. The decline represents a recalibration of rate views as investors eye more monetary easing from the Fed than had been penciled in just a week ago.

The 10-year dipped for a third day on Friday, edging down to 4.597% after reaching a 52-week high above 5.8% on Tuesday.

The reversal has been fueled by a trifecta of developments that are causing investors to turn more optimistic about the outlook for Fed rate cuts this year.

The mood is a stark departure from last week's fears of higher inflation and higher rates, which weighed on stocks and sent yields surging as rate-cut hopes seemed all but dashed after a shockingly strong December jobs report.

Markets got the first ingredient for a rally on Wednesday when traders took in a cooler-than-expected December inflation. Headline inflation came in as anticipated, but core inflation, which excludes volatile food and energy prices, rose 3.2% year over year, slightly lower than the 3.3% core price growth economists were expecting.

Traders quickly adjusted their outlook for Fed rate cuts in the coming year, causing the 10-year Treasury yield to slide as much as 14 basis points on Wednesday.

"Core Inflation isn't accelerating and that's the story. The market may have had its hair on fire about inflation running away again, but the data do not support that conclusion. What we are seeing is the typical ebb and flow of the data as inflation is being pushed out of the system," Jamie Cox, a managing partner at Harris Financial Group, said following the release of the CPI report.

Others noted that the data should put to bed any fears that the Fed could potentially hike rates again this year amid a hot economy and the potential for inflation to rise as a result of the new administration's policies,.

"December's relatively benign CPI report should douse speculation that the Fed's next move will be to tighten policy," Sam Tombs, chief US economist at Pantheon Macroeconomics, said in a note. "Looking ahead, we continue to think that core PCE inflation will fall slightly over the next two months, bolstering the case for the FOMC to ease policy at its meeting in late March."

The good news continued as the week rolled on. Investors on Thursday took in retail sales data, which missed estimates and decelerated from the prior month. Sales ticked just 0.4% higher in December, down from the expected 0.6% growth, according to Commerce Department data released on Thursday.

Investors see the slightly weaker economic data as good news, as a cooler economy gives the Fed more breathing room.

The final component that helped stocks at the end of the week was dovish commentary from a top Fed official. Speaking to CNBC on Thursday, Fed Governor Christopher Waller said the central bank could cut rates in the first half of the year if inflation data continues to improve.

If inflation slows enough, the Fed could issue more rate cuts than previously anticipated, Waller said, noting that as many as three or four quarter-point rate cuts were possible in such a scenario.

"As long as the data comes in good on inflation or continues on that path, then I can certainly see rate cuts happening sooner than maybe the markets are pricing in," Waller added.

Investors have pushed out the possibility of another 25 basis-point rate cut until June, but traders are placing bets that the Fed could take on a more aggressive easing cycle in 2025 than previously thought.

The odds that the Fed could cut rates three times or more rose to 20% as of Friday, up from just 7% odds priced in a week ago, according to the CME FedWatch tool.