'The Fed is going to overdo it': Financial markets finally react to U.S. central bank's 2023 rate outlook and weak data

Financial markets finally absorbed the Federal Reserve's stridently hawkish interest-rate outlook for 2023, weighing the prospects of a 5%-plus level in borrowing costs in the new year against fresh signs of a weakening U.S. economy on Thursday. A bigger-than-expected drop in November's retail sales plus weak regional manufacturing data added to the growing impression that the world's largest economy is about to tip into a recession next year. Dow industrials had its worst day in three months on such fears Thursday, while investors fled to the safety of long-term government debt and sent the dollar -- a traditional haven during times of turmoil -- to a two-day high.Wednesday's initial skepticism in some corners of the financial market to the Fed's higher-than-expected 2023 median rate projection of 5.1% and need to keep rates up for longer was replaced by investors' gradual realization that the central bank might actually do what it says -- just as the world's largest economy appears to be teetering. The Fed's main policy rate target currently sits between 4.25% and 4.5%, up from almost zero at the start of this year. "To some extent, markets are still digesting the takeaways from the Fed's dot plot, the press conference, and the statement," said Michael Reynolds, vice president of investment strategy at Philadelphia-based Glenmede, which manages $38.5 billion in assets. "There are a lot of different things at play. On one hand, the Fed is going to raise rates more. But on the other hand, that's also increasing the probability of a recession. Investors may be buying into that fact," resulting in Thursday's flight to safety.While the bond market was reacting to "many cross currents" of risk, stock markets were behaving in a "more one-directional" manner and fell sharply as the result of November's disappointing retail-sales data plus the prospect of more Fed rate hikes in 2023, Reynolds said via phone. "We've been waiting for monetary policy to hit the consumer, and now it has -- putting a dent in the odds of a soft landing. "In the hours that followed the Fed's hawkish emphasis on restoring price stability on Wednesday, financial markets reacted in a surprisingly muted way: Dow industrials and the S&P 500 , for instance, partially reversed their late-day losses by the end of the New York trading session. And 2-, 10- and 30-year Treasury yields finished the day just slightly higher -- suggesting that even bond investors doubted the Fed's inflation-fighting resolve.Deutsche Bank's Jim Reid, Henry Allen and others summed up the FOMC meeting and reaction like this: "You would probably say that [Fed officials] were hawkish, but that the market doesn't believe they will be," they wrote in a Thursday morning note.As Thursday's trading session wore on, though, sentiment appeared to shift as central banks outside the U.S. also hiked rates. Read: ECB slows rate hikes, but signals it's far from doneAll three major U.S. stock indexes finished Thursday's session lower, with Dow industrials logging its worst day since Sept. 13. A swell of buying in Treasurys pushed the 10- BX:TMUBMUSD10Y and 30-year yields to one-week lows. Gold added to Fed-day losses, while oil futures ended lower, as the ICE U.S. Dollar Index DXY jumped 0.8%.Pimco global economic advisor Richard Clarida is among those who said on Thursday that avoiding at least a modest recession in the U.S. will be a challenge. Meanwhile, Capital Economics' Andrew Hunter said he sees a mild downturn in the first half of 2023 "as the Fed's relentless hawkishness takes its toll. ""Markets are now realizing, and it's now sinking in, that the bar for rate cuts next year is going to be really high," Daniel Tenengauzer, BNY Mellon's head of markets strategy, said via phone. If anything, falling bond yields, which some had initially read as expressing doubt about the Fed's resolve, are "telling you the Fed is going to overdo it."