Stocks close sharply down after Powell says rates will rise more than expected

US stocks fell sharply on Tuesday after a dose of reality from Fed Chair Jerome Powell, who paved the way for a larger-than-expected rate hike at the central bank policy meeting later this month. 

In remarks to the Senate Banking Committee on Tuesday morning, Powell said interest rate hikes are “likely to be higher than previously anticipated."

The news sent investors reeling, with all three major indexes dropping steeply.

Market expectations for a half-point rate hike spiked, shifting from a 30% probability to almost 70% by day's end, according to the CME FedWatch Tool. 

Treasury yields soared and the 2-year reached its highest level since 2007. A key recession indicator was also triggered in Tuesday trading as the yield on the 2-year Treasury note fell below that of the 10-year Treasury note, a sign that investors are worried about the immediate economic future.

Powell continues his two-day testimony on Wednesday morning as he speaks before the House Financial Services Committee.

In other economic news, data from the Fed showed that even though consumers continued to spend in January, they took on significantly less debt than economists were expecting. 

In corporate news, bank shares fell as investors worried that higher interest rates would lead to recession. JPMorgan Chase shares dropped by nearly 3%, Bank of America stock shed 3.2% and Wells Fargo fell 4.7%.

The Dow closed 575 points, or 1.7%, lower.

The S&P 500 was down 1.5%.

The Nasdaq Composite fell 1.3%.

As stocks settle after the trading day, levels might still change slightly.

Favorable weather and a strong job market kept consumers spending in January, but overall debt balances didn't grow as significantly as expected as high interest rates took their toll.

US consumers' outstanding credit increased by $14.8 billion in January from the month before, according to data released Tuesday by the Federal Reserve. Economists were projecting a $20 billion jump, per Refinitiv.

It's the second-lowest monthly gain since January 2022 and follows a December where credit balances grew by a revised $10.7 billion.

Non-revolving credit — which includes car loans and student loans — grew at a modest 3.7% seasonally adjusted annualized basis; while revolving credit, which mostly includes credit cards, grew at an annual rate of 11.1%.

The gains in revolving credit accumulation aligns with a surge in consumer spending during January. Retail sales accelerated 3% from December and broad-based consumer spending rose 1.8%, Commerce Department data showed.

However, the high-interest rate environment is weighing on affordability and, in turn, used car sales, said Warren Kornfeld, a senior vice president with Moody's.

"We expect that credit card loan growth will continue at an elevated pace," Kornfeld said in a note. "However, annual loan growth will slow in 2023 to around 10% down from around 15% in 2022. Credit card loan growth will remain elevated due to continued strong credit card spending as well as consumers increasingly tapping their credit cards to maintain spending as still elevated inflation continues to take a bite out of disposable income and excess savings."

A key recession signal grew stronger Tuesday when the yield curve inverted to a level not seen since September 1981 in response to hawkish comments from Fed Chair Jerome Powell.

The closely watched economic indicator showed the yield on the 2-year Treasury note has fallen below that of the 10-year Treasury note, a sign that investors are more nervous about the immediate future than the longer term.

A 10-year Treasury typically delivers a higher rate of return than shorter-term notes, since an investor’s money is committed for longer. Shorter-duration Treasury notes, such as a 2-year or a 3-year bond, generally offer lower yields, because risks are more predictable than over a longer time horizon. 

But when the return on a 10-year note is lower than the 2-year, that indicates a pessimistic outlook on the part of investors and a reluctance to commit their money.

A yield curve inversion has preceded every single recession since 1955, according to research from the Federal Reserve Bank of San Francisco.

Investors also braced themselves for a potentially larger-than-expected rate hike at the Fed's next meeting later this month. Expectations that that the central bank will raise interest rates by a half-point jumped to a 67.5% probability, according to the CME FedWatch Tool. The tool had shown a 69.4% probability of a smaller, quarter-rate increase ahead of Powell's remarks.

Stocks deepened their losses Tuesday after the Senate Banking Committee's interrogation of Fed Chair Jerome Powell about his plans for the economy.

The Dow slid by more than 500 points, or 1.5%, by mid-afternoon. The S&P 500 slipped 1.4% and the Nasdaq Composite fell 0.9%.

The selloff came after Powell warned in his testimony that the "ultimate level of interest rates is likely to be higher than previously anticipated."

Powell also said Congress must raise the US government's borrowing limit, warning of possible "long-standing harm."

Democratic Senator Elizabeth Warren, a frequent critic of Federal Reserve Chair Jerome Powell, grilled Powell Tuesday morning about the impact interest rate hikes have on the economy and the labor market, arguing higher inflation would be preferable to higher unemployment.

In a heated exchange, Warren asked Powell to address the 2 million people who the Fed predicts would lose their jobs if unemployment rates increase to the Fed's projected 4.6% by the end of the year.

"What would you say to them? How would you explain your view that they need to lose their jobs?" asked Warren.

Powell argued that all Americans are suffering under the weight of higher prices. Inflation is extremely high and it's hurting the working people of this country badly.

"Will working people be better off if we just walk away from our jobs and inflation remains 5-6%?" Powell fired back. "We are taking the only measures we have to bring inflation down."

Warren countered that the Fed has a "terrible track record of containing modest increases in the unemployment rate," Once the economy "starts shedding jobs," she said "it's kind of like a runaway train."

The unemployment rate currently sits at 3.4%, its lowest level in 54 years.

"We actually don't think that we need to see a sharp or enormous increase in unemployment to get inflation under control," said Powell. Raising the interest rate by another percentage point would still leave the unemployment rate at historic lows, he said.

Warren concluded her line of questioning by telling Powell that he is "gambling with people's lives."

"You claim to the idea that there's only one solution, layoff millions of workers we need a fed that will fight for families," said Warren. "And if you're not going to lead that charge, we need someone at the Fed who will."

Fed Chair Jerome Powell voiced support Tuesday for regulations on the cryptocurrency market, which functions as a parallel financial system without a set regulatory framework.

"It's 'same activity, same regulation,'" Powell said. "People are going to assume when they deal with something that looks like a money market fund that it has the same regulation as a money market fund or a bank deposit."

Officials have become increasingly focused on tightening federal oversight of the volatile digital asset market, which has been hammered by bankruptcies and scandals, including the collapse of FTX late last year.

Fed Chair Jerome Powell told lawmakers in no uncertain terms that Congress must raise the US government's borrowing limit to avid "extraordinarily adverse" damage to the global economy.

"We do not seek to play a role in these policy issues. But at the end of the day, there's only one solution that to this problem, and that is Congress," the Fed chair said. "Congress really needs to raise the dead ceiling... If we fail to do so, I think that the consequences are hard to estimate, but they could be extraordinarily adverse and could do longstanding harm." 

The United States is expected to default on its debt obligations as soon as this summer if Congress doesn’t address the debt ceiling. But Republicans have demanded that any such move be accompanied by steep spending cuts.

The high-stakes, high-profile bickering over the debt ceiling raises its own risks, Senator Robert Menendez said during Tuesday's hearing. He asked Powell: "Isn't even this constant fight putting into question a possibility that the United States will not honor its full faith and credit have consequences within the economy?"

"In principle, it could," Powell said. "I think markets and observers tend to ... think that it will work out, and it has in the past worked out. So it needs to work out this time." 

The Federal Reserve's future policymaking actions will depend heavily on movement within three key inflationary sectors: Goods, housing and the broader services sector, Fed Chair Jerome Powell said Tuesday in response to a line of questioning from Republican Senator Katie Britt of Alabama.

In goods, the Fed needs the disinflation already underway to continue, he said.

In housing, the Fed needs time pass, he added, noting the lagging data will soon reflect new, less pricey leases being signed.

In services, "we'll be watching that very carefully," Powell said, adding the sector accounts for 56% of consumer spending. Powell previously noted in Tuesday's testimony that services — which includes a variety of industries such has financial, medical, personal care, travel, and leisure — is a driving source of today's inflation.

Powell also noted that the Fed's efforts to date have likely yet to be fully felt.

"We raised rates very quickly last year, and we know that monetary tightening policy has delayed effects; it takes a while for the full effects to be seen," he said.

Still, those monetary policy tools do have limitations, and this bout of inflation isn't like those seen in the past, Powell cautioned.

"We have many unusual factors, and I don't think anybody knows with confidence how this is going to play out," he said.

Market expectations for a half-point rate hike surged Tuesday after Fed Chair Jerome Powell reaffirmed his hawkish stance against inflation.The CME FedWatch Tool shows a 48.4% probability of a half-point increase, up from 30.6%.

Leading up to Chair Powell's Congressional testimony on Tuesday, markets were expecting the Fed to make another quarter-point rate hike at its next meeting two weeks from now.

The CME FedWatch Tool was showing a 69.4% probability of such a hike prior to Powell's testimony. One month ago, the probability for a half-point increase was 3.3%, according to the CME FedWatch Tool.

Still, the tool shows a 51.6% probability that the Fed will raise rates by another quarter point, showing a near evenly split divide in the market about the central bank's highly anticipated next move.

Powell warned in his remarks that the central bank could raise interest rates higher than previously expected after a slew of economic data suggested that the economy remains too hot.