The past two Federal Reserve meetings added fuel to the dramatic S&P 500 rally since late October, with strong gains over 1% on both Nov. 1 and Dec. 13. Yet the chances that Fed chair Jerome Powell will provide more fodder for a surging stock market likely went out the window with last week's fourth-quarter GDP report.
Fed Gov. Waller: 'As Good As It Gets'
The best guide to Fed policy in recent months has been the comments of Fed Gov. Christopher Waller, who had been a fixture of the hawkish consensus until late last year. Odds of one last Fed rate hike collapsed in mid-October after Waller and Dallas Fed President Lorie Logan said the rise in the 10-year Treasury yield was doing the Fed's work for it by tightening financial markets.
Then, on Nov. 28, in a speech titled "Something Appears To Be Giving," Waller said that rate cuts would be warranted if inflation continued to ease over the next three to five months. That pretty much cemented the outlook for a rate cut by the May 1 Fed meeting.
Waller continued to toe a dovish line with his Jan. 16 speech, "Almost as Good as It Gets ... But Will It Last?"
"The data we have received the last few months is allowing the Committee to consider cutting the policy rate in 2024," Waller said at the time.
Yet Waller's seemingly dovish pronouncement was premised on his expectation that Q4 GDP growth would come in between 1% and 2% — not the 3.3% rate reported on Jan. 25.
Even if growth had moderated, Waller indicated changes in Fed policy needed to be "carefully calibrated and not rushed." But with the GDP report and surging S&P 500 casting doubt on whether an economic moderation is at hand, the Fed may not see a need to begin lowering its key rate.
The Real Fed Policy Rate
Actually, the economy is displaying a near-ideal combination of strong growth and falling inflation. In the second half of 2023, real GDP grew at a 4.1% pace, as the Fed's primary measure of core inflation ran at just a 2% rate — in line with the Fed's target. That brought the 12-month core inflation rate down to 3.15% from 4.6% midyear.
That means the Fed's benchmark overnight interest rate, now set between 5.25% and 5.5% is at about 2.2 percentage points above the rate of inflation and that gap could grow to more than 3 percentage points if the tame recent inflation trend continues.
The upshot is that Fed policy is growing very tight in real terms. Keep in mind that the Fed's quarterly projections in December showed that policymakers think the neutral federal funds rate, one that neither accelerates nor slows economic growth, is just 0.5%.
That implies the Fed has plenty of room to cut interest rates, and it explains why markets expect five or six quarter-point rate cuts this year.
What Will Powell Say?
Powell helped light a fire under the S&P 500 on Dec. 13 when he said that the Fed is very cognizant of the risk of keeping policy tight for too long. That eased any remaining concern about a recession caused by Fed overtightening.
But with the economy still showing strength and the S&P 500 rallying to new heights — and possibly in the early stages of a 1990s-like boom led by artificial intelligence stocks — Powell will likely strike a more cautious tone.
Markets could react if he delves into the question of whether strong economic growth despite a high federal funds rate may mean that the neutral Fed policy rate is higher than believed. If the real federal funds rate is significantly higher than 0.5%, it might suggest that the 10-year Treasury yield may be stuck above 4%.
Powell also is likely to discuss coming changes to Fed quantitative tightening, the shrinking of its balance sheet as Treasuries and government-backed mortgage securities purchased early in the pandemic emergency mature. That's something Wall Street is eager to hear about. But that probably won't provide the S&P 500 a spark today.
Deutsche Bank economists wrote this week that they expect the Fed's discussion over QT to extend for a couple of meetings. They expect a tapering of balance-sheet runoff to happen in June, but for the unloading of assets to continue at a more moderate pace, rather than phaseout, at least initially.
Fed Rate Cut Odds
As of Wednesday morning, markets are pricing in 49.6% odds of a rate cut on March 20 and 89% odds of a cut by May 1.
S&P 500
S&P 500 futures slipped 0.5% in early Wednesday stock market action after earnings reports from Google and Microsoft on Tuesday afternoon.
The slightly negative tone may make markets less likely to shake off any dissonant message from Fed chair Powell. However, markets may get a lift from release of the Fed policy statement at 2 p.m., since it's likely to adopt a balanced posture, ditching its prior tightening bias as a possible prelude to rate cuts.
Be sure to read IBD's The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
