A frothy stock market suffered a steep fall Tuesday, as an unexpectedly hot January consumer-price index reading reminded investors that the Federal Reserve's long-fought battle against inflation isn't yet won.
"The markets just went too far, too fast and the Fed's reality is setting in right now," said Kent Engelke, chief economic strategist and managing director at Capitol Securities Management, in a phone interview.
Reality can be painful. The Dow Jones Industrial Average DJIA dropped nearly 760 points at its low and ended the day down roughly 525 points, or 1.4%. The S&P 500 SPX tumbled 1.4%, while the Nasdaq Composite COMP shed 1.8%.
Treasurys sold off sharply, sending yields, which move in the opposite direction to bond prices, soaring as traders recalibrated rate-cut expectations. The yield on the 2-year Treasury BX:TMUBMUSD02Y jumped 18.7 basis points to 4.654%, its highest level since Dec. 12.
The consumer-price index rose 0.3% in January, with the year-over-year rate falling to 3.1% from 3.4% a month earlier. The core rate - which excludes volatile food and energy costs - rose 0.4%, a tick above Wall Street expectations, leaving the year-over-year core rate unchanged from December at 3.9%.
Investors were reminded that CPI release days can be volatile. All three major indexes had their worst performance on a CPI day since Sept. 13, 2022, according to Dow Jones Market Data.
The problem is that investors had thought inflation worries were in the rearview mirror, pricing in as many as six quarter-point rate cuts by the Federal Reserve this year and driving the S&P 500 SPX above the 5,000-point milestone last week. At the same time, the Dow Jones Industrial Average DJIA notched a string of record-high closes while the Nasdaq Composite COMP approached its own record territory.
The Fed, of course, had been pushing back against those expectations. The dot-plot forecast had penciled in only three rate cuts in 2024, and Fed Chair Jerome Powell and other officials had consistently urged against the notion that rate cuts could come as early as March.
Fed-funds futures traders have now all but abandoned the prospects of a March rate cut, while pricing in a roughly 37% chance of at least a quarter-point cut by the Fed's May meeting - down from more than 60% on Monday and 100% a month ago. They now see just over a 50% probability of a total of four quarter-point cuts by the end of the year.
Some observers worried that further rounds of stubborn inflation data could force the Fed - which has so far signaled that it's next move will be a rate cut - and investors to change their tune altogether.
"Given that core CPI came in at 3.9% again - and didn't drop to 3.7%, which was the consensus forecast - then it not only throws the timing of Fed rate cuts into question, but potentially opens the door to a possibility that we haven't seen the last Fed rate hike in this cycle," said Chris Zaccarelli, chief investment officer for Independent Advisor Alliance, in emailed comments.
Others warned against reading too much into one month's data, but noted that the figures would clearly not be read as good news by Fed policymakers.
"The final mile towards the Fed's 2% target was always going to be slow, erratic and frustrating," said Seema Shah, chief global strategist at Principal Asset Management. "Today's data is not what markets or the Fed would have liked to see, but it's important not to overreact and jump to the assumption that an inflationary resurgence is developing."
Capitol Securities' Engelke said stocks had "discounted all the positives" heading into Tuesday's data, leaving the market vulnerable to a sharp selloff that was likely exacerbated by algorithmic trading.
A near-term pullback could prove healthy for the rally, he added. Based on simple moving averages, a pullback to the 4,800-point level for the S&P 500 would seem reasonable, with 4,600 in sight if that line of support fails to hold.
A retreat on that order "would actually be healthy for the market to wring out the excesses," Engelke said. "We've got to get complacency out of the market. ... A couple big down days that leave the market down 5% or 8% in a week, and people get really scared."