Fed Rate Hike Locked In; Here’s What Will Drive Markets
The setup for the Federal Reserve meeting Tuesday and Wednesday looks promising for a continuation of the latest Dow Jones Industrial Average rally. A second straight 75-basis-point rate hike is already baked in, so the stock market reaction to Wednesday’s monetary policy pronouncements should hinge on what Fed chief Jerome Powell signals about September’s meeting, nearly two months away.
Inflation finally appears to be past the peak, with the price of gas and other commodities sliding. Meanwhile, a raft of unexpectedly weak economic data has begun piling up. Thursday morning’s GDP release may feature back-to-back quarters of negative growth, if White House recession denials are a clue. With that backdrop, a moderation of the Fed’s rate-hiking pace to a half point in September seems logical.
Yet market pricing still indicates 50% odds of a third-straight hike of 75 basis points on Sept. 21, according to CME Group’s FedWatch page. Fed guidance pointing to a still-hefty move of half a point would amount to easier-than-expected policy and should be enough to keep investors’ rally caps on.
So what could — and probably will — go wrong for those betting on a sustained stock-market bounce with an assist from this week’s Fed meeting?
At the moment, inflation is still too high and unemployment too low for the Fed to worry about cushioning the economy’s landing. Plus, Fed officials always consider how markets may react to monetary policy changes. At this point, they would likely see a Dow Jones rally as premature, since it would work against their efforts to cool demand via tighter financial conditions. So they may take care not to give investors grounds for near-term optimism.
Unexpected Federal Reserve Pivot?
Wall Street strategists increasingly expect the Federal Reserve to pivot to a slower pace of rate hikes. As slow growth turns to a brush with recession, the Fed is seen pausing rate hikes. By the spring of 2023, a rate cut may be up for consideration. The rally in the dollar vs. foreign currencies, which has already contributed to tighter financial conditions, is a key part of their thesis. The strong dollar may lower the Fed’s interest-rate ceiling in this cycle.
While the bullish pivot scenario makes some sense, the Fed may surprise with a different kind of pivot. Recently, Powell has played up the importance of top-line inflation, including volatile food and energy prices, as what is most relevant for consumers. That makes sense, because if their gas and grocery bills jump, workers may be more determined to push for bigger pay raises. Those big wage hikes, in turn, may compel companies to pass along labor inflation via price hikes to their customers.
But now that the surge in gas prices and, to some extent, food prices is abating, Powell may shift the focus to a component of inflation that has yet to exhibit progress. The June CPI report showed prices for nonenergy services — categories like rent, medical services and transportation that account for 57% of household budgets — rising 5.5% from a year ago, the highest inflation rate since 1991.
This kind of inflation is seen as stickier, since it’s less subject to supply swings and more connected to wage growth. Powell has said that the Fed needs to see both inflation and inflation pressures coming down in a convincing way. Persistent services inflation shows there’s a lot more work to be done.
Presumably, the Federal Reserve will get a look at Thursday’s GDP report ahead of Wednesday’s policy decisions. Wouldn’t back-to-back quarters of negative GDP growth put pressure on the Fed to slow its rate-hiking path?
Not necessarily. The Fed can make a decent argument that real growth is negative only because inflation is so high. Walmart‘s (WMT) profit warning on Monday suggested something similar, with the company saying comparable sales growth would be higher than expected.
Getting inflation down is the key to turning nominal spending increases into real ones, Powell might say.
Even the Fed’s improbable soft-landing projections issued in June envision unemployment creeping up to 4.1%. It now stands at 3.6%, near a half-century low. The Fed sees higher unemployment as part of the process of tackling inflation, rather than something to avoid.
There also may be talk about whether the Fed’s key interest rate is really in neutral territory. It’s set to rise to a range of 2.25%-2.5%. Policymakers believe the long-run neutral rate of interest is about 2.4%. That assumes inflation returns to its target. As long as the Fed’s benchmark rate is negative in real terms — below the rate of inflation — it is arguably still accommodative.
One key for a bullish pivot is the notion that Fed has regained credibility in fighting inflation with back-to-back hikes of 75 basis points. If the Fed doesn’t have to be as worried about expectations for elevated inflation becoming entrenched, policymakers should feel some flexibility to hike at a more moderate pace, adjusting as needed.
Yet it’s probably too soon for the Fed to let down its guard even a little. The biggest outbreak of inflation since the 1980s involves so many wild cards out of the Fed’s control. That includes everything from Russia’s invasion of Ukraine to pandemic-related shutdowns. Policymakers won’t take for granted that their luck has finally turned.
Plus, Powell has noted that disinflationary forces of recent decades have been pushing in the other direction. Most notable are labor force demographics and globalization.
Dow Jones Setup
The Dow Jones fell Tuesday following Walmart’s Monday night warning. However, the Dow has climbed 7% from its June 17 closing low. That cut its loss to just 13% from its Jan. 4 all-time closing high. The S&P has retraced 8.2% of its losses and now stands 17.3% off its peak close. The Nasdaq has enjoyed a 10.7% bounce, but remains 26.6% below its peak.
The rally has come as the 10-year Treasury yield, after spiking close to 3.5%, has fallen back. It’s now near 2.78% as investors anticipate a further slowdown amid Federal Reserve tightening, eventually leading to rate cuts.
In late 2018, all it took was a 20% market drawdown for the Fed to end its program of rate hikes and balance-sheet tightening. By the fall of 2019, the Fed was cutting rates and buying more assets. But inflation was running below target at the time, not at a generational high.
The Dow Jones and other major indexes have broken above their 50-day lines for the first time since April. That comes on optimism about a Fed pivot, but the uptrends are currently under pressure. Be sure to read IBD’s daily The Big Picture column after every trading day to stay on top of the market trend and what it means for your trading decisions.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
YOU MAY ALSO LIKE:
The Fed Recession: Tax Data Flashes Huge Red Flag
Why This IBD Tool Simplifies The Search For Top Stocks
Catch The Next Big Winning Stock With MarketSmith
Want To Get Quick Profits And Avoid Big Losses? Try SwingTrader
Best Growth Stocks To Buy And Watch
#Fed #Rate #Hike #Locked #Heres #Drive #Markets