- A hot inflation report for April ramped up odds for a rate hike by year-end.
- The shift is likely to make Fed Chair Kevin Warsh's job more difficult.
- It also represents a growing headwind for the red-hot AI trade, as well as the stock market at large.
It's easy to forget now, but one of the main bull arguments for stocks heading into 2026 was the prospect of rate cuts. The idea was simple: Lower interest rates stimulate the economy, and effectively serve as rocket fuel for stocks.
But as the year progressed — and especially after the US invaded Iran — rate cut hopes fell by the wayside. Inflation became too much of a worry. Yet stocks persisted with a series of record highs, driven instead by AI advancement that investors rushed to keep up with.
Now, in an ironic twist of fate, the direction of interest rates could pose the biggest threat to the AI trade. That's because a rate hikein 2026 is now seen as a much more likely outcome than a cut. Goodbye rocket fuel.
So what changed? Look no further than two recent economic data points:
- April jobs report (May 8): The 115,000 nonfarm payrolls added in April were far more than the 65,000 predicted. March job additions were also revised higher.
- April CPI (May 12): The 3.8% increase from a year ago was the biggest jump in three years, and came in above expectations.
The combination of the two has been enough to firmly put rate hikes back on the table. Investors are now pricing in a 32% chance of one by year-end, up sharply from a week ago. For the April 2027 Fed meeting, odds of a hike are actually higher than for a hold. Meanwhile, chances of a cut in 2026 have dwindled to just 3%.
This shift didn't happen overnight. Take a look at the 10-year yield since the start of the Iran war in late February. It's up 52 basis points, and finished Tuesday at its highest level in 10 months. This shows that, for weeks, investors have been bracing for surging inflation and the prospect of a more hawkish rate path.
The market's move towards rate cuts comes at an awkward time for incoming Fed Chair Kevin Warsh. His appointment by Donald Trump initially had investors thinking that Warsh would get in line with the multiple rate cuts the president wants. But now, with inflation running hot and yields following suit, his hands may be tied.
What this all means for investors is that the stock market — and, by extension, the AI trade — is facing a new hurdle. The Nasdaq 100 certainly felt it on Tuesday, falling more than 2% at intraday lows.
Ultimately, can AI-driven productivity and earnings growth continue to offset rising inflation and monetary-policy headwinds? It very well could. After all, it's dispatched all challengers to date. But there's no denying the path is getting increasingly difficult.
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