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The Fed's 'plausible' economic outcome leaves little margin for investors

This is The Takeaway from today's Morning Brief, which you can sign up to receive in your inbox every morning along with:

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Stocks plunged on Thursday and the S&P 500 (^GSPC) suffered its worst day since March. Meanwhile in bonds, the belly of the US Treasury yield curve surged to 15-year highs, highlighting increasing investor risk aversion following Wednesday's Federal Reserve decision.

Fed Chair Jay Powell stuck to his guns Wednesday with the "higher for longer" mantra and left the Fed's main policy rate unchanged. But he threw tepid water — if not cold water — on expectations that the US economy will avoid recession this cycle.

Responding to a reporter question, Powell said that a soft landing is not the Fed's baseline expectation; it's merely a "plausible outcome."

At the long end of the US yield curve, bond vigilantes are running with the remarks — driving the 10-year near 4.5%, the highest level since 2007.

At the short end of the curve, the Fed's policy rate remains restrictive. And ironically, the more inflation cools, the more restrictive the Fed's policy rate will become. That's because the so-called real policy rate is the Fed's overnight benchmark rate minus core inflation.

If the Fed holds its nominal policy rate where it currently is while inflation cools, simple math says that the real policy rate will increase. And that's increasingly what the Fed itself is signaling.

As Yahoo Finance's Myles Udland noted Thursday in this column, Fed officials now see fewer rate cuts in 2024 and 2025 than they did at their June meeting.

"Higher for longer" effectively means "restrictive for longer."

In a private note to clients, Alfonso Peccatiello, founder & CEO of TheMacroCompass.com, says that Powell and the Fed are sitting "between a rock and a hard place," making it a "tricky situation" for most investors.

Risk assets like stocks have "limited upside" yet bond investors aren't faring much better. For bonds to surge higher, yields would need to decline substantially, which would be mean a hard landing.

Peccatiello ominously concludes that bonds can't rally substantially "unless something breaks for good."

For the stock investors, the surge in yields is bad news for those who rode the megacap stock wave higher earlier in the year. The triple-digit gains of Nvidia (NVDA), Tesla (TSLA), and Meta (META) are fading, as Apple (AAPL) hovers near five-month lows. Those longer-duration stocks tend to suffer the most when bond yields suddenly move higher.

Nasdaq 100 Heat Map - 2 Days
Nasdaq 100 Heat Map - 2 Days

Yet, investors have also lost confidence in cyclical stocks, as economic murkiness and headwinds abound. The industrial sector, for instance, has suffered the worst large-cap returns over the last month, down 3.5%.

But all is not lost for investors willing to be nimble. Bonds may settle down after the latest repricing cycle ends, and seasonal factors will once again favor stocks in a few weeks. As ever, shorter-term traders may soon wade into the market's murky waters, but the Fed has all but cemented challenges ahead for buy-and-hold investors in this environment.

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