The ground just shifted ahead of today's Federal Reserve meeting. A quarter-point rate hike still appears likely. Yet as regional bank stocks plunged on Tuesday, markets effectively issued a warning to Fed chair Jerome Powell. The upshot: If the Fed doesn't signal that today's hike is the last one, the S&P 500 could be in for an ugly day.
Future Fed Rate Hike Odds Fall To Zero
Here's what happened: As of Monday afternoon, markets were still pricing in nearly 30% odds that the Federal Reserve would hike today and then once more on June 14. Yet Tuesday saw continued fallout for regional bank stocks, defying FDIC hopes that the arranged sale of First Republic Bank to JPMorgan Chase would help stabilize markets. PacWest Bancorp plunged 27.8% and Western Alliance Bancorp 15.1%. Even super regional banks got creamed, with Comerica down 12.4% and KeyCorp 9.4%.
By Tuesday afternoon, near-30% odds of a June rate hike fell to zero. Odds of June hike creeped back up to 5% early Wednesday, after payroll processor ADP estimated that private employers added a surprisingly strong 296,000 jobs in April.
Yet the 2-year Treasury yield slipped further under 4%, the lowest in more than a year, excluding the height of the banking panic in the first half of March. That's a sign the economy is on thin ice.
Those bank stock declines are symptomatic of the tightening of bank credit that was already underway before SVB Financial Group's abrupt failure in March escalated the problem. The Fed is partly to blame, having let inflation get away, then resorted to rapid-fire rate hikes to contain it. Now banks have plenty of low-interest loans on their books, along with troubled commercial real estate loans. Yet banks are having to fight to hang onto their deposits by offering high savings-account interest rates that can compete with money market interest rates around 5%.
With bank credit tightening and claims for unemployment benefits climbing as layoffs mount, markets are betting on multiple rate cuts in the second half of the year.
There's also another reason chances of a June rate hike have suddenly gone out the window. With federal tax payments coming in more slowly than expected, both Treasury Secretary Janet Yellen and the Congressional Budget Office issued notices on Monday that time for a deal to raise the debt ceiling will run out by early June. Markets may already be volatile around that deadline, even without Fed uncertainty.
Federal Reserve Meeting Policy Statement
Wall Street isn't asking the Federal Reserve to come to the rescue yet. But investors need a signal that the Fed won't strangle the economy and sacrifice regional banks to kill inflation.
A status quo Fed meeting statement — "some additional policy firming may be appropriate" — would keep a bias toward tightening and likely send the S&P 500 sliding as markets reprice the odds of a June rate hike.
The Fed doesn't need to go so far as to say that rate hikes are done. Simply dropping its tightening bias and suspending guidance will be interpreted as an intention to stand pat — barring a big inflation surprise.
That approach would turn today's rate hike into a "dovish hike," wrote Nomura economists Aichi Amemiya and Jacob Meyer.
Still, the Nomura economists think that Fed chair Powell will make clear that near-term rate cuts are unlikely, "pushing against the current market pricing of a couple of rate cuts by the end of this year."
Futures Rise On PacWest Update After PACW Dives On Sales Report
Will Fed Provide S&P 500 Rally Fuel?
Since futures pricing already implies no chance of a June rate hike, how might the S&P 500 respond if the Fed meeting statement drops the tightening bias? That wouldn't seem to be major rally fuel, but don't rule out some moderate fireworks.
Just consider what happened after last July's Fed meeting when chair Powell decided to stop offering specific forward guidance. At the time, "making decisions meeting by meeting" simply meant keeping options open between another 75-basis-point rate hike in September and a more moderate, perhaps 50-basis-point, move.
Yet markets interpreted the glass as half-full and the S&P 500 went on a 5% run over three sessions.
The S&P 500 rose 0.35% to 4135 in early Wednesday stock market action. On Monday, the S&P 500 made a run at the Feb. 2 high of 4195 before reversing lower. A Fed pause signal might set the S&P 500 for another try at busting through the top of its trading range dating back to late August.
On the perhaps unlikely chance that the Fed keeps its tightening bias, the first real line of support for the S&P 500 would be near the 50-day moving average around 4036.
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