Wall Street has already panicked about how far the Federal Reserve will go in raising interest rates – including a decidedly 75 basis point hike on Wednesday. An unexpectedly hot CPI report in August sent the S&P 500 down 4.8% last week, as the 10-year Treasury yield touched its highest level since 2011. That setup left the Federal Reserve a very direct decision on Wednesday: Either confirm bad news markets come to terms with, or give the S&P 500 reason to go higher.
This should not be a difficult call. The Fed cannot allow anything like a repeat of the summer rush, which saw the S&P 500 climb 17% from its lows and the 10-year Treasury yield fell from nearly 3.5% to 2.6%. This loosening of financial conditions reversed much of the Fed’s tightening of action during the spring.
The cost of this reversal became very clear with last week’s CPI report: a very strong labor market continues to keep inflation on a very high path. While the overall inflation rate fell to 8.3%, prices for essential services, such as rent, health care and transportation, rose 0.6% in the month and 6.1% from a year ago, the fastest pace since February 1991.
Fed Policy: Tighter, Longer
The summer recovery was already beginning to unravel on August 26, when Federal Reserve Chairman Jerome Powell, in his speech in Jackson Hole, U.S., abandoned his earlier optimism that the US economy could avoid a recession. Instead, Powell signaled that the Fed would keep policy tighter for longer, shutting down the economy so that the current outbreak of inflation does not turn into a chronic, 1970s-style catastrophe.
Powell’s speech began repricing the market for Fed policy expectations, canceling out the dovish impression he gave at his July 27 press conference that helped the S&P 500 cut its 24% loss by more than half, pulling out of a bear market.
The hot CPI reading for August delivered another big jolt. Markets are now pricing in a third straight rate hike of 75 basis points on Wednesday, followed by a fourth on November 2. Markets are also seeing better than double odds for a half pip rate hike on December 14th.
The Federal Reserve’s final interest rate
Adding to all that, markets expect the Fed’s key rate to end this year with a target range of either 4%-4.25% or, more likely, 4.25%-4.5%. This may not be all. The odds are down above 50% for an additional quarter-point rise to the 4.5%-4.75% range next March or May, according to the CME Group’s FedWatch page.
Here’s why market expectations of the Fed’s peak cycle rate, or final rate, are important at this week’s Federal Reserve meeting. Besides adjusting the current policy position, Fed members will reveal new projections for rate hike expectations over the next few years.
“Showing an interest rate below the market would ease financial conditions, which would have an adverse effect on the Fed’s goal of lowering demand,” Anita Markowska, Jefferies’ chief financial economist, wrote in a note on Friday.
It expects the new quarterly forecast to show that the benchmark federal funds rate will end in 2023 with a target range of 4.25%-4.5%.
Will the Fed’s forecast show a recession?
A secondary question is whether the Fed will continue to embrace the soft landing scenario at least implicitly. The latest batch of forecasts in June, although not quite as rosy as those in March, indicated that inflation could be whipped up without much pain. The US economy is still growing at 1.7% in 2023, which is just below the long-term trend, with unemployment rising to 3.9%. The new forecast could show growth closer to the flat line and unemployment rising above 4% next year. However, the Fed is unlikely to cut interest rates next year.
That was the message of Powell’s Jackson Hole speech. Even if the unemployment rate rises and the economy faces a recession, the Fed won’t cut until inflation heads to 2% in a convincing fashion. The Fed is guided by the experience of the 1970s, when policymakers repeatedly lowered interest rates as unemployment rose, only to see inflation flare up again.
S&P 500 Bear Market Looming
If there is good news for the S&P 500, it is that the rate hike shock has already begun. While the hawkish tone of the Fed’s meeting policy statement and new expectations will keep the bulls in a cage, a crash may be averted. But the S&P 500 could continue lower as the outlook for the economy and earnings weaken, so a return to bear market territory is likely. There is a good chance the S&P 500 will retest its June lows, so investors will need to be patient.
After Tuesday’s 1.1% loss, the S&P 500 stood 19.6% below its Jan. 3 closing high, though still 5.2% above its closing low on June 16. The Dow Jones Industrial Average is down 16.6% from its closing peak, leaving it just 2.7% above its 52-week closing low in June. The Nasdaq Composite is down 29.85% from its record closing high but is still 7.3% off its June low.
Be sure to read the IBD’s “Big Picture” column after each trading day for the latest news on the trend of the prevailing stock market and what that means for your trading decisions.
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