Wall Street has already had its freaks over how much the Federal Reserve will hike interest rates — including a virtually certain 75 basis point hike on Wednesday. The hotter-than-expected August CPI report sent the S&P 500 down 4.8% last week as the 10-year Treasury yield hit its highest level since 2011. This setup left the Fed with a fairly simple decision on Wednesday: either markets confirming bad news come to terms with it, or give the S&P 500 reason to rally.
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This shouldn’t be a difficult call. The Fed can’t afford to allow anything like a repeat of the summer rally, which saw the S&P 500 surge 17% from its lows and the 10-year Treasury yield falling to 2.6% from nearly 3.5%. This easing in financial conditions reversed much of the Fed’s tightening work in the spring.
The cost of this reversal was made all too clear with last week’s CPI report: a far too strong labor market is still keeping inflation far too high. While the headline inflation rate fell to 8.3%, prices for core services such as rent, healthcare and transportation rose 0.6% month-on-month and 6.1% year-on-year, the fastest pace since February 1991.
Fed policy: tighter for longer
The summer rally had already begun to reverse on August 26, when Fed Chair Jerome Powell dropped earlier optimism that the US economy could avoid a recession in his speech in Jackson Hole, Wyoming. Instead, Powell signaled that the Fed would keep policies tighter and the economy grounded for longer lest the current inflationary spree turn into a chronic 1970s-style catastrophe.
Powell’s speech ushered in a reassessment of the Fed’s monetary policy outlook, reversing the dovish impression he made at his July 27 news conference, which had helped the S&P 500 cut its 24% loss by more than half and one exit bear market.
August’s hot CPI read provided another major shock. Markets are now pricing in a third straight rate hike of 75 basis points on Wednesday, then a fourth on November 2nd. Markets also see better odds for a half-point increase on December 14th.
Federal Reserve final interest rate
All in all, markets expect the Federal Reserve’s interest rate to end this year with a target range of either 4% to 4.25% or a little more likely 4.25% to 4.5%. And maybe that’s not all. According to CME Group’s FedWatch page, the odds of another quarter-point rise to over 50% next March or May have risen to a range of 4.5% to 4.75%.
This is why market expectations for the peak Fed rate of the cycle, or end rate, are so important for this week’s Fed meeting. In addition to adjusting the current monetary policy framework, the members of the Fed Committee will publish new forecasts for the prospects for interest rate hikes over the next few years.
“Showing a below-market terminal rate would lead to an easing of financial conditions, which would be counterproductive to the Fed’s goal of reducing demand,” Jefferies financial economist Aneta Markowska wrote in a statement on Friday.
It anticipates that the new quarterly projections will show the benchmark overnight interest rate until the end of 2023, with a target range of 4.25% to 4.5%.
Will the Fed forecast show a recession?
A secondary question is whether the Fed will continue to adopt a soft landing scenario, at least implicitly. The latest projections in June, while not quite as rosy as those in March, suggested that inflation could be whipped up with little pain. The US economy still grew 1.7% in 2023, just a hair’s breadth below the long-term trend, as unemployment edged up to 3.9%. New forecasts could show growth closer to zero and unemployment to rise above 4% next year. Still, the Fed is unlikely to cut 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 pulls back to 2% in a convincing manner. The Fed is guided by the experience of the 1970s, when policymakers repeatedly cut 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 is already priced in. While the hawkish tone of the Fed’s meeting policy statement and new forecasts will keep bulls in the cage, a washout could be avoided. But the S&P 500 could still drop lower as the economic and earnings outlook weakens, making a return to the bear market likely. There’s a good chance the S&P 500 will retest its June lows, so investors need to be patient.
After shedding 1.1% on Tuesday, the S&P 500 was 19.6% below its all-time closing high on Jan. 3, but still 5.2% above its closing low on June 16. The Dow Jones Industrial Average is down 16.6% from its peak, down just 2.7% from June’s 52-week closing low. The Nasdaq Composite is down 29.85% from its record closing high but remains 7.3% below its June low.
Be sure to read the IBD column, The Big Picture, after each trading day for the latest on the prevailing stock market trend and what it means for your trading decisions.
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