- The Stock Market is lurking ahead of the Federal Reserve Bank’s meeting.
- The S&P 500 fell 4.8% last week as a reaction to the unexpectedly hot August CPI report, and the 10-year Treasury yield hit its highest level since 2011.
Jim Boykin, the Chief Investment analyst of Investmentals, emphasized, “It looks clear that the Fed is going to raise rates on Tuesday. We don’t see how they can do it without ruining the stock market. I’m not sure how much lower the stock market can fall, but this hike might be the initiation of a long-term bear session.”
According to economic analysts, the Fed’s decision on Wednesday is very simple as a consequence of this setup: Either confirm the negative stories that markets are already accepting or offer a reason for the S&P 500 to rise.
That choice shouldn’t be tough. The S&P 500 climbed 17% off its lows during the summer rally, and the yield on the 10-year Treasury dropped from about 3.5% to 2.6%. The Fed cannot afford to allow anything close to that to occur again. The Fed’s initiatives to tighten the economy throughout the spring were substantially undermined by that easing of financial conditions.
The CPI report from last week made the price of that reversal all too obvious: Still, an overly strong job market keeps inflation at an unacceptably high level. Prices for vital services, such as rent, healthcare, and transportation, increased 0.6% in the month and 6.1% from a year ago, the quickest rate since February 1991, even if the overall inflation rate dropped to 8.3%.
The summer rally had already begun to unravel on August 26, when Fed Chair Jerome Powell renounced his earlier optimism that the U.S. economy could avert recession. Powell suggested that the Fed will retain tighter policy for longer, sustaining the economy and barring the current inflation outbreak from degenerating into a recurring crisis similar to the 1970s.
The dovish impression Powell delivered during his news conference on July 27 helped the S&P 500 cut its 24% loss by more than half, escaping a bear market. However, Powell’s speech initiated a market repricing of the Fed’s policy outlook.
Another major surprise came from the high CPI reading for August. Currently, markets are predicting a 3rd consecutive 75-basis-point rate hike on Wednesday and a fourth on November 2. Markets also predict better-than-even odds of a December 14 rise of 0.5 points.
In the end, markets estimate that the Federal Reserve’s key policy rate will have a target range of either 4%-4.25% or, rather more likely, 4.25%-4.5%. The series may not end there. According to CME Group’s FedWatch page, the probability of one more quarter-point rise to a range of 4.5%-4.75% in March or May has increased above 50%.
Here’s why the Fed meeting this week’s market expectations for the cycle’s peak Fed rate, or terminal rate, is so crucial. Members of the Fed committee will present and predict a range for the rate-hike prognosis over the next few years, in addition to modifying the current policy setting.
As Jefferies chief financial economist Aneta Markowska wrote in a Friday note, showing a below-market terminal rate would lead to an easing in financial conditions, which would be counterproductive to the Fed’s goal of reducing demand.
She expects the new quarterly projections will show the benchmark federal funds rate ending in 2023 with a target range of 4.25%–4.5%.
Whether the Fed will continue to, at least on some level, favor a soft-landing scenario is a side issue. Though not quite as optimistic as those in March, the most recent projections from June indicated that inflation could be managed with little effort. Even though unemployment rose to 3.9%, the U.S. economy was still expected to grow 1.7% in 2023, just barely below the long-term norm. According to the latest forecast, next year’s growth could be closer to a plateau and the jobless rate could rise above 4%. However, the Fed is not likely to reduce rates in 2023.
The Fed won’t start cutting rates until there is convincing proof that inflation is back to 2%, even if unemployment rises and the economy suffers a recession. The Fed is being led by the lessons learned during the 1970s, when rate cuts were repeatedly made as unemployment increased, only for inflation to return.
The fact that the rate-hike shock is already being priced in is wonderful news for the S&P 500. While the bulls will be limited by the hawkish tone of the Fed meeting policy statement and the new projections, a wash-out may be avoided. However, as the economy and earnings forecast worsen, the S&P 500 may remain in decline, which makes a return to the bear market more likely. Investors must be patient because there is a good chance that the S&P 500 will test its June lows again.
After Monday’s 0.7% rise, the S&P 500 was 18.7% below its all-time closing high from January 3 but 6.4% above its closing low from June 16. Even though the Dow Jones industrial average is now only 3.8% below its 52-week closing low, it has fallen a more moderate 15.7% from its top close. The Nasdaq composite is up 8.35% from its June low but is down 28.2% from its record closing high.