The Federal Reserve's "dovish hike" on May 3 helped set the stage for the next phase of the S&P 500 rally that has followed. Despite hiking its key interest rate above 5%, the Fed, by dropping its bias toward additional rate hikes, essentially gave the stock market room to run.
Today, we could be in for the reverse. The Federal Reserve looks certain to skip a rate hike, sticking to its guidance. However, Wall Street expects policymakers to signal their intent to hike again, barring a pronounced softening of the job market and core services inflation. Just how hawkish the Fed's signals are tomorrow will likely determine how the S&P 500 responds.
Federal Reserve Meeting Statement
The Fed will have three ways to signal that the June pause in rate hikes is probably over: the policy statement, new economic projections, and Chairman Jerome Powell's post-meeting news conference. Deutsche Bank economists expect the Fed to use all three.
"We expect the statement will be hawkishly adjusted to note the potential for further tightening at 'coming meetings,' " Deutsche Bank economists wrote.
The compilation of each Fed policymaker's federal funds rate projection, known as the dot-plot, also is likely to show an additional hike, they predict. Further, Powell's message "should skew hawkish," given resilient economic data and easing financial conditions.
The Deutsche Bank economists anticipate one further quarter-point hike to a range of 5.25% to 5.5% at the July 26 meeting.
If the Fed wants to send a message to investors and potentially stifle a more powerful S&P 500 rally that could offset monetary tightening, look for a change in the policy statement.
On May 3, the Fed dropped language indicating that the policymaking committee "anticipates some additional policy firming." In its place, the new Fed meeting statement pledged to closely monitor incoming data to assess "the extent to which additional firming may be appropriate."
In other words, policymakers no longer anticipated rate hikes but would reconsider if economic data warranted.
Rate Hike Projections
Now the question is whether the data warrants a hike. Part of the Fed's calculation will be whether financial conditions, of which stock prices are one important reflection, may have eased too much to achieve policymakers' goal of bringing down inflation and wage growth.
The latest batch of quarterly projections in March showed that a clear minority of policymakers — seven of 18 — expected the federal funds rate to peak above the current 5%-5.25% range. Only four of 18 expected multiple hikes above the current level.
The S&P 500 is likely to behave better if the new projections show the Fed is closely divided over an additional hike. But if a strong majority is now inclined to hike again, the stock market will likely take note.
After the CPI report showed headline inflation falling to 4% on Tuesday, markets are pricing in just 5% odds of a rate hike, down from around 20% on Monday. But markets still see around 66% odds of a July hike, according to the CME FedWatch Tool.
Fed Decision On Tap; What Investors Need Now
The Fed's Summer Break
Chair Powell said after the May 3 Federal Reserve meeting that policymakers could "afford to look at the data and make a careful assessment." The lagged impact of rate hikes and the outflow of deposits from regional banks both pointed to a softening of the economy, he indicated.
Yet so far the economic data has come in mixed. "An array of leading indicators now points to recession," wrote Ian Shepherdson, chief economist at Pantheon Macroeconomics. They include the National Federation of Independent Business monthly survey, various manufacturing surveys, and declining bank lending.
Both employment gains and the Fed's key inflation gauges remain well above policymakers' comfort zone. But "it is just a matter of time before they buckle," Shepherdson said.
The key question is whether it will happen in time for the Fed's July meeting. After that comes the Fed's summer break. The subsequent meeting isn't for eight weeks, so the Fed may need to see clear evidence of economic weakness to skip a rate hike next month. That leaves only two CPI reports, including tomorrow's, and one monthly jobs report.
S&P 500
The S&P 500 rose 0.65% in Tuesday stock market action. That followed Monday's 0.9% gain and marked the highest close for the S&P 500 since April 2022. S&P 500 futures are pointing slightly higher early Wednesday.
The S&P 500's climb of more than 20% off October's bear-market low means we're in a new bull market. Stock market history would suggest more gains will follow over the next year, though a potential recession could create quite a detour. On top of a likely additional rate hike, the S&P 500 also will have to withstand the contrary tide of Federal Reserve quantitative tightening and a surge in Treasury issuance.
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