Bonds say inflation has peaked, but here’s what Cathie Wood says the stock market needs to hear to stage a bona fide rally

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Bullish stock investors have gotten punched in the month so far this week, after a relatively cheery kickoff to 2023 following an ugly 2022.

Cathie Wood, however, has some thoughts about what might truly light a fire under those hoping to place optimistic long bets on equities.

The Dow Jones Industrial Average DJIA, -0.76% is down 2.9%, the S&P 500 index SPX, -0.76% is off 2.5% and the tech-heavy Nasdaq Composite Index COMP, -0.96% is down over 2% in a holiday-abbreviated trading week that saw some gloominess chip away at hard-fought year-to-date gains.

Although the Nasdaq is up 3.7%, the S&P 500 has gained 1.6% and the blue-chip Dow has edged up 0.5% in 2023, Wood said Thursday there’s a key factor that may be holding back investors and markets.

Yes, it’s the Fed. But more specifically, it’s what the Fed hasn’t said, Wood argued.

The U.S. central bank has been pushing up benchmark interest rates in an effort to quash inflation, which in turn has quelled the purchases of speculative assets.

And even though there are signs that inflation may be stabilizing, if not retreating, Wood said that investors need to hear the Fed say that it’s going to cease driving rates higher.

The ARK Invest founder said a pullback, rather than an increase in interest rates, representing increase in borrowing costs, signals that markets are betting that inflation is, indeed, being adequately managed.

Indeed, U.S. wholesale prices sank 0.5% in December, marking the biggest decline since April 2020, when the U.S. economy was first stricken by the COVID pandemic.

The decline in inflation was largely attributed to falling prices of food and gasoline, but the slide underscored growing evidence of inflation’s retrenchment.

The Fed is trying to restore the annual increase in inflation to pre-pandemic levels of 2% by sharply raising interest rates, which could potentially push the U.S. into a recession.

Bond yields, which fall as prices increase, have been acting as if the Fed may be ready to end its rate increases. Yields tend to rise as investors sell debt and prices fall in anticipation of higher rates on newly issued Treasurys.

So far this year, yields have fallen — instead of rising.

“We’re very happy to see bond yields going down here,” Wood said Thursday during a quarterly seminar held for followers and investors of her ARK Invest suite of funds.

“Much like in [the] early ’80s, equity markets need to hear the Fed say that it is signaling the end of interest rates moving up,” Wood said, referencing inflation’s peak at around a 40-year high, the highest since the early 1980s.  

That improved inflation dynamic might translate to a better setup for embattled ARK, and its flagship ARK Innovation fund.

Wood’s exchange-traded funds were once darlings of the post-COVID-19 speculative boom on Wall Street. The ARK Innovation ARKK, -3.23% fund rose around 150% during 2020 and helped to burnish Wood’s reputation, but the rapid rise in interest rates helped to capsize her growth-focused investing strategy. ARK Innovation ended 2022 down nearly 67% after falling 24% in 2021.

However, the flagship fund is currently enjoying a pop, up over 11% the year to date.

Wood has estimated that the U.S. may already be in a recession and that the degree to which benchmark interest rates (up 18-fold, she estimates) may be more impactful than the terminal increase of rates, which economists refer to as the terminal rate.

“I think the change in interest rates is more important than the level,” she said. Federal funds rates currently stand at a range between 4.25% and 4.50%, after being near 0% during the height of pandemic in 2020.

To be sure, the Fed may be reluctant to make any definitive changes to its current policy.

On Thursday, Federal Reserve Vice Chairman Lael Brainard, one of the most dovish of the top U.S. central bankers, talked about the need to keep interest rates high.

“Even with the recent moderation, inflation remains high, and policy will need to be sufficiently restrictive for some time to make sure inflation returns to 2% on a sustained basis,” Brainard said in a speech at the University of Chicago Booth School of Business.

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