S&P 500, Nasdaq end lower as Treasury yields rise on Fed rate hike expectations

By Isabel Wang and Frances Yue

Two-year Treasury yield ends at highest in nearly two weeks

U.S. stocks ended mostly lower on Wednesday, led by a sharp fall in the Nasdaq Composite, as Treasury yields rose, undermining the valuation of technology stocks, after the Bank of Canada unexpectedly raised interest rates which added to apprehension about the Federal Reserve's interest-rate decision next week.

How stocks traded

On Tuesday, the S&P 500 closed at its highest level in 10 months, while the Nasdaq Composite closed at a 14-month high.

What drove markets

The S&P 500 and the Nasdaq Composite fell Wednesday, after reaching the highest levels since 2022 in the previous session. The rally in technology stocks faded as Treasury yields rose when the Bank of Canada unexpectedly raised its benchmark interest rate by a quarter of a percentage point, resuming its monetary tightening after a four-month pause.

On Tuesday, Australia's central bank also defied expectations, delivering a second straight quarter-percentage-point interest-rate increase.

U.S. investors were worried a widely expected pause in the Federal Reserve interest-rate hiking cycle next week may risk a similar experience in the U.S., as the potential for resurgent inflation and stronger-than-expected consumer spending will provoke surprise rate hikes.

See: Bank of Canada surprise rate hike reminds U.S. investors 'pause' doesn't mean 'stop'

Traders priced in a 30% probability that the Federal Reserve will deliver another 25-basis point hike after its meeting on June 14, according to the CME FedWatch tool That's up from 21.8% one day ago. Fed officials have indicated that a pause is justified though, while emphasizing that skipping a rate increase in June doesn't mean they can't deliver a hike at a later date.

Andrew Hunter, deputy chief U.S. economist at Capital Economics said even though there appears to be enough support on the FOMC (Federal Open Market Committee) for a pause at next week's meeting, the statement and new projections due out next Wednesday will make clear that "this is not the end of the hiking cycle."

"We now expect rates to be raised again at the July meeting. And although we still think that falling inflation and weak GDP growth will convince the Fed to move to the sidelines soon, it is now likely to take until early next year for officials to be ready to start cutting again," Hunter wrote in a Wednesday note.

Chances of a 25-basis-point hike which brings the policy rate to the 5.25%-5.50% range in July was priced at 51.8% Wednesday afternoon.

"I think there's a realization among central banks but also investors that the cost of capital wasn't yet at the tipping point. We're not sending the world economy into recession," said Phillip Colmar, partner and global strategist at MRB Partners.

"That means you price out the recession risk, and it's not bad for equities. But the flip side of it is that [central banks' tightening] policy may not be done," said Colmar.

"So you got a better growth backdrop, but you got higher interest rates," noted Colmar. It takes off some of the profits off of big tech companies, which have been leading stocks gains so far this year, but it "broadens the rally out", Colmar said in a call.

However, the small-cap Russell 2000 index advanced 1.8% on Wednesday, extending its rally that sent the index to its highest close since March 9 in the previous session. The index is also outperforming the Nasdaq Composite by 5.04 percentage points so far this month, its largest outperformance in the first five trading days of a month since October 2020, according to Dow Jones Market Data.

See:Small-cap stocks surge as broader U.S. market stalls. Here's why

Bill Hench, portfolio manager of the First Eagle Small Cap Opportunity Fund, said small-cap stocks, which have been lagging behind its large-cap peers, are "logical places" to look now.

"If suddenly people think we are not going to get a recession," they would start looking at sectors that have underperformed their peers for the past two years, Hench said.

Adding to the pressure on stocks was more gloom from China, where data showed exports fell 7.5% from a year ago in May, dropping from 8.5% growth seen in April, and much worse than the 1.0% decline seen from economists polled by The Wall Street Journal. A string of recent weak updates have heightened expectations that officials will soon make moves to stimulate the economy.

In U.S. economic data, the U.S. international trade deficit jumped 23% in April to a six-month high of $74.6 billion, reflecting an increase in imports such as cellphones and foreign autos. The trade gap rose from $60.6 billion in March. Larger deficits subtract from gross domestic product, the official scorecard for the economy.

Read:What if the S&P 500 fumbles its bear-market exit? What strategists think of the role of tech in this rally

For the past few days, the S&P 500 has been on the verge of exiting its longest bear-market run since 1948. A close above 4,292.44 would mark a 20% rally off the bear-market closing low of 3,577.03 set on Oct. 12, 2022, according to Dow Jones Market Data. That would meet a widely used definition of the end of a bear market.

Companies in focus

-- Barbara Kollmeyer contributed.

-Isabel Wang

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06-07-23 1628ET

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