What a few weeks for investors. Yes, the S&P 500 lost a little ground last week. But let’s not miss the forest for the trees. After more than a 10% drop in only two days after Liberation Day on April 2, fear and panic was in the air. As we noted many times last month though, some of the worst days of the year tend to take place right around the best days. Well, this time wasn’t any different, as the past few weeks have seen stocks soar unlike many other times in history.
Some Good News for the Bulls
Last Thursday officially marked one month from the April 8 S&P 500 lows, and as bad as things felt back then, they’ve felt pretty good since. The S&P 500 soared more than 13% over the ensuing month. This was the best gain over a one-month period since we came off the pandemic lows in March 2020, and huge monthly gains like this are perfectly consistent with potentially higher prices going forward.
Here’s the good news. We found 13 other times stocks gained at least 13% over a one-month period and the future returns were very strong. In fact, only twice were prices lower a year later and that was during the early 2000s tech bubble bear market. The past four times this happened saw at least double-digit returns going out the next year. The bottom line is a huge monthly surge like we just saw is yet another clue the lows for 2025 are likely in and better times could be coming for investors.
More Reasons To Think the Lows Are In
The S&P 500 fell 18.9% from the February 19 peak to the April 8 lows, in what we are calling a near-bear market. Trust me, if you were there it sure felt like a bear market, as investors were battered and bruised.
The good news is stocks have now recovered half of that near-bear market, potentially a good sign. In fact, looking at the past 16 bear or near bear markets only once did stocks go on to make new lows after half of the bear market was recovered. Of course, that was the very last time, in 2022, but this is still a good sign. Lastly, a year later stocks were higher an incredible 16 out of 16 times after recovering half of the bear (or near bear) market.
The Fed Is Buying Into the Tariff Bull Case, but That Pushes Out Cuts
The Federal Reserve (Fed) didn’t move policy rates at their May meeting, keeping them in the 4.25 – 4.50% range. This was widely expected, but all eyes (and ears) were on how they would telegraph future moves. Short answer: they didn’t. The only major change in the official post-meeting statement was that risks of both higher unemployment and higher inflation have risen, but that raised a very obvious question.
If unemployment rises and inflation also rises, which side of their mandate would the Fed prioritize, maximum employment or low and stable inflation?
Fed Chair Jerome Powell punted on the answer in several ways, mostly falling back on the refrain that they’re unable to see which way things will play out. He admitted that prioritizing one side of their mandate over the other will be a difficult judgement, but the good news is that they don’t have to decide now since the labor market looks healthy — so they can afford to wait and watch, without being in a hurry. Uncertainty has clearly increased, along with downside risks, but there’s nothing distinctly negative in the data yet. The Fed still rates the economy as healthy, albeit with downbeat sentiment amongst consumers and businesses.
Focus Likely To Be on Taming Inflation, at the Expense of Employment
If push comes to shove it looks like the Fed will prioritize inflation over employment. For one thing, Powell once again noted that “without price stability you cannot achieve long periods of labor market stability.”
This effectively means that if the Fed is forced to choose between taming inflation versus avoiding higher unemployment, they’re going to do what it takes to tame inflation first.
Moreover, Powell added that policy is currently in a good place, which gives them a lot of flexibility to act down the road depending on how the data comes in. But by his own admission, policy right now is “sufficiently restrictive” despite the fact that the labor market is not a source of inflationary pressure.
Keep in mind that pausing on rate cuts does not just leave us with a benign status quo. Even without moving rates, policy is implicitly getting tighter because wage growth is easing. Historically, a fed funds rate sitting well above the pace of wages has constricted the economy and ultimately these situations ended up in recessions. The relationship between rates and wage growth matters even if rates stay steady.
In short, policy is tight right now and it’s going to remain tight until the Fed sees more data.
Powell also mentioned that eventually they may decide between their two mandates by focusing on the one that is further away from their goal. So, let’s play this out.
Core inflation, as measured by the Fed’s preferred personal consumption expenditures metric (PCE), is currently at 2.7% year over year (as of March). That is already elevated relative to the Fed’s target of 2%. But tariff front-running and higher import costs are likely to at least partially feed into consumer prices. In fact, the Manheim Used Vehicle Index, which tracks auction prices for used vehicles, rose 2.7% in April, a significant jump compared to recent readings in the range of 0.2%. That takes prices to their highest level since October 2023 and came about as Americans rushed to buy cars to get ahead of tariffs (which pushed inventories down). This is going to show up in official inflation data, albeit with a lag. We’re likely to see a sharp pickup in goods inflation over the next several months, including vehicles, appliances, apparel, and consumer electronics, pushing core PCE up to 3.5 – 4% by year end. Even if it turns out to be temporary (or “transitory”), that’s a whole 1.5 – 2%-points above the Fed’s goal.
Now consider the employment side. Powell noted that the labor market is at or close to full employment right now, with the unemployment rate of 4.2% is not that far off from historical lows. The Fed’s base case (going by their March projections) is for the employment rate to hit 4.4% by year end. Unless the unemployment rate suddenly surges to 4.8 – 5.0%, it’s hard to see the Fed prioritizing the employment side of its mandate, especially if core inflation is running near 4%.
The long and short of this: expect the Fed to stay on pause for longer. And if they do cut, that’s not going to be good news, because it’ll mean the labor market has broken (and the Fed’s likely stepping in too late).
The Fed’s Also Optimistic About the Tariff Situation
It looks like the Fed is at least provisionally buying into what we would call the bull case on tariffs. Powell did highlight that since Liberation Day tariffs, the administration has entered negotiations, and so the tariff picture could change materially. What could that mean? In our view, the bull-case scenario would be tariffs coming down significantly from extreme levels, perhaps down to only 10% additional tariffs on most goods, and slightly higher on Chinese imports. If this is indeed the Fed’s outlook, it squares with their decision to stand pat and not act pre-emptively to rescue the economy (especially with hard data, including recent payroll data, suggesting nothing’s broken yet).
Of course, that also means rates stay elevated, and “sufficiently restrictive” for longer, with the Fed not cutting interest rates at their next meeting in June, and perhaps not even in July. Investors have also been shifting market-implied pricing for near-term rate cuts quite significantly.
- The probability of a cut in June fell from about 34% on Wednesday morning (ahead of the Fed announcement later that day) to under 20% by the end of the week.
- The probability of at least one cut by July moved down from 100% to close to 60%.
The market is still pricing in at least three cuts in 2025 and another two in the first half of 2026. That would be a relatively quick pace of cuts of about 1.5%-points over eight meetings. In other words, markets are expecting policy to stay tight in the near term, but an economic slowdown later in the year (and into 2026) may push the Fed to cut more rapidly. There’s a reason why longer-term bond yields fell after the Fed meeting, despite near-term rate cut expectations fading.
As we’ve repeatedly noted in blogs, and even in our 2025 Outlook, elevated rates are a key risk to the economy. Cyclical areas of the economy like manufacturing (which will also be hit by higher input costs) and housing will continue to struggle. Mortgage applications have picked up in recent weeks and are currently running 13% above where they were a year ago, but they’re still a whopping 37% below average 2019 levels. Refinancings are down 59% from average 2019 levels. The whole tariff situation, and ensuing uncertainty, simply increases the risk of tight monetary policy, with elevated interest rates becoming a larger and larger drag on the economy.
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