Stocks fell again on Thursday, defying hopes that a four-day losing streak would be snapped. This is now the longest market sell off for 2023, as the trajectory of US and global interest rates remains the dominant market theme. The S&P 500 has erased nearly half of its gains so far this year, which is adding to the narrative that the early 2023 boost for stocks was a bear market rally, and things could be downhill from here. As the data stacks up in favour of further Federal Reserve rate hikes, the question now is how long will the sell off last, and how much further will the Federal Reserve go in rising interest rates?

When good news is bad news

At the start of this year, who would have thought that the most important chart to watch out for would be the economic surprise index? The Citigroup chart measures the balance of positive and negative economic surprises in the US and is used as a gauge for economic strength. As you can see below, the US economic surprise index jumped into positive territory back in early January, and although the absolute rate of positive surprises is low on a historical level, they are now back at their highest level since 2021.

Chart 1: US Citigroup Economic Surprise Index

This chart encapsulates the mood in the market: good economic news is bad for risk sentiment. The good news is bad news theme is driven by the rapid repricing in the pace of Fed interest rates. According to CME’s Fedwatch tool, the market is now pricing in a near 30% chance of a 50-basis point rate increase from the Federal Reserve at its meeting next month, this is up from a 1.5% chance just a few weeks ago. This is a rapid change in sentiment, that has also weighed on global bonds. The US 2-year yield is up some 60 basis points so far this month, while the 10-year yield is up nearly 50 basis points in the same period. This is a dramatic tightening in financial conditions, the average US 30-year mortgage rate has also jumped in the past month, and is currently 6.5%, earlier this month it was less than 6.1%.

Growth and value stocks are moving together

The tightening in financial conditions has big implications for stocks, however, the market is not reacting as one would expect when the market is rapidly repricing interest rate risk. Usually, one would assume that this would hit tech stocks, which tend to get hurt by expectations that interest rates will rise as it increases the discount rate, which reduces the value of their future cash flows. However, this is not the case in the current market sell off. The IT sector is one of the best performing on the S&P 500 on Thursday, as Nvidia’s share price jumped by 14%. The multinational IT company, beat earnings and revenue expectations in Q4 2022 and reported strong growth in its data centre business. However, analysts rushed to upgrade their forecasts for Nvidia on the back of their plans to push into AI, while at the same time maintaining cost discipline. This more than made up for intel’s poor performance, which saw its share price fall a touch on Thursday after it announced that it would slash its dividend.

Stay flexible

One thing to remember about this “bear market rally” is that the selloff is not going in a straight line and the market shakeout is not even. In the UK, the aviation manufacturer Rolls Royce’s share price was up nearly 24% today, after it reported Q4 earnings that beat expectations, saying that recovering international air travel helped its bottom line. With a strong consumer still a feature of the global economy, the benefits for companies like Rolls Royce could last for some time. What is interesting in the outperformance of both Nvidia, and Rolls Royce on Thursday is that one is considered a growth company, while Rolls Royce is considered a value company. Thus, at this phase of the market cycle, where we don’t know if we are in bear market rally, the start of a market rally or a sideways move while we wait to see what the Fed does next, it pays off to be flexible and not to stick too closely to one investment style.

Trading in a less predictable environment

Overall, trading is harder and less predictable as we move further into 2023. When it comes to interest rates, the hawks are in charge. In the UK, Catherine Mann, a member of the Bank of England’s Monetary Policy Committee, and an arch hawk, said that there will be no pivot in UK interest rates anytime soon. She said that more interest rate increases are necessary to counter the threat of rising inflation. Mann also pointed out that financial conditions have loosened as the markets begin to look for the peak in interest rates. Although Mann’s views differ from those of Huw Pill and Andrew Bailey, she makes a strong argument for the higher for longer interest rate narrative. Elsewhere, in the US, the Fed’s preferred measure of inflation, the core PCE index came in well above expectations for Q4 2022. It rose to 4.3% from 3.9% in Q3 and adds to the argument that core inflation is likely to remain sticky in the US for some time. There was also more tightening in the labour market, initial US jobless claims came in lower than expected at 192k, suggesting that more job growth is leading to fewer people signing on for unemployment benefit.

Higher for longer narrative hits the FX market

The hawkishness from most central banks in the G7 complicates the FX picture. At the start of this year the dollar looked like it would extend its recovery, however, the dollar index is stalling around the 104.50 mark, as GBP/USD hovers around the $1.20 handle. We continue to think that the USD looks like a good bet in the current environment, and on the back of the US economic surprise index. Thus, if the US data continues to outperform, then it suggests that stocks will underperform, and the dollar could be back in command of the G10 FX space. Overall, watching out for economic data is key in this environment.