A Fed-Rate Surprise Could Be a Problem for the Stock Market

The Federal Reserve continues to play catch-up in its fight against inflation, and there’s no doubt that interest rates are headed higher after its meeting ends on Wednesday.

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It’s Fed meeting week, and the market doesn’t exactly know what’s going to happen. After a last-minute pivot in June and with recent economic data coming in mixed, the discussion among investors and economists is all about what the central bank’s next move will be.

The latest inflation reading for June showed a 1.3% rise in the consumer price index during the month, stretching its one-year increase to a whopping 9.1%. The Federal Reserve continues to play catch up in its fight against inflation, and there’s no doubt that interest rates are going higher after the Federal Open Market Committee’s two-day meeting concludes on Wednesday. The debate is over the size of the move.

Futures pricing on Monday implied a 77.5% chance of a 75 basis point increase in the fed-funds rate target range, to 2.25% to 2.50%, according to the CME FedWatch Tool. The balance, 22.5%, was for a 100 basis point hike. Those odds have swung widely over the past month as economic data has come in and Fed officials have made public remarks, increasingly or decreasingly pricing in hikes of 50, 75, and 100 basis points.

“The atypical volatility in policy expectations reflects the fact that there are clear indications of a slowdown in all the real growth data except in the payroll employment report, i.e. that the Fed’s tightening is already having a significant effect on the economy,” wrote Steven Ricchiuto, U.S. chief economist at Mizuho Securities, on Monday. “But as long as the payroll numbers remain a contradictory indicator, investors can’t be confident that the Fed is getting close to the end of the rate-hike cycle.”

The greatest challenge for the Fed is that much of today’s inflation is caused by supply-side issues. Monetary policy and changes in interest rates can’t do anything about Covid-19 related shutdowns in China, spikes in commodity prices due to the Russia/Ukraine war, or shortages of semiconductors stalling auto production. Instead, the Fed can bring down demand for goods to levels that match limited supply while decreasing spending in other areas like housing by making borrowing more expensive for consumers and businesses—working against fast-rising prices there.

By design, that means slowing down the economy—a trend that has shown up in surveys and narrow indicators of activity in some sectors, but not in the U.S. labor market. The worst-case scenario for investors is that the unemployment rate begins to creep higher and other economic data continues to weaken, while inflation stubbornly remains elevated. That’s a recipe for stagflation, and would mean the Fed needs to choose between supporting the economy and bringing down inflation.

“Central banks think they can curb inflation and cause only a mild slowdown, whereas this is unlikely in reality, in our view,” wrote BlackRock Investment Institute strategists in a commentary published on Monday. “We see more volatility ahead until central banks take sides in the stark trade-off between growth and inflation they are facing.”

That goes for both this week’s FOMC meeting and the next several. The committee has three more scheduled monetary policy decisions to make this year: in late September, early November, and mid December. The trajectories of inflation and the labor market will determine the path that interest rates take—and also the market. Higher interest rates tend to be a negative for growth stocks, while a weaker economy is bad for cyclicals. But markets move ahead of reality, and once investors become more comfortable with the Fed’s intentions, they can look ahead to the next thing.

The toughest dynamic is the present uncertainty, which keeps cash on the sidelines and breeds volatility as traders price in every new shred of information.

The short-term reaction to a 100-basis point hike on Wednesday could be a considerable selloff in the market. Growth stocks’ valuations would be hurt by higher interest rates, while the greater tightening by the Fed would increase recession odds, harming cyclicals. Defensive utilities or consumer staples might be best off, but even those bond-proxy sectors wouldn’t be immune. Bond prices would decline as their yields rise. The U.S. dollar may be the only winner in that scenario.

A smaller-than-expected 50-basis point increase may mean a short-term rally, as the pressure from higher rates on valuations lessens and the Fed exhibits caution on the economic strain it is causing. But that bounce might not last, as commentators would start worrying about the Fed not doing enough to fight inflation—and whether a smaller cut was a warning sign about the health of the economy.

A 75-basis point hike should be the outcome traders are hoping for.

“It is reasonable to expect another bear market rally on any whiff of ‘peak hawkishness’…but make no mistake, central banks are likely not finished tightening policy and the Fed put is, for all intents and purposes, gone for the foreseeable future,” wrote Jason Vaillancourt, global macro strategist at Putnam Investments.

That leaves the parsing of chairman Jerome Powell’s press conference on Wednesday afternoon as the most important determinant of the market’s reaction. With the Fed’s next meeting not for two months, a wait-and-see approach may be most likely—don’t expect a ton of concrete guidance.

As of Monday, futures pricing implied roughly even odds of a fed-funds rate target range upper limit of 3.0% and 3.25%, according to the CME FedWatch Tool. Depending on the July hike, that could mean a 50 or 75 basis point move.

Write to Nicholas Jasinski at nicholas.jasinski@barrons.com

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