All eyes will be on the US central bank which is widely expected to raise rates by 75 basis points on Wednesday for the fourth time. the central bank has raised its policy rate five times since March, most recently to a range of 3%-3.25% in September, after dropping the lower bound to 0% in 2020 at the onset of the pandemic. The market for wagers on the Fed’s benchmark last week priced in a peak of 5%, the highest yet, for the first half of 2023. while investors will be dissecting Chair Jerome Powell’s commentary for guidance on future moves. US stocks have rallied over the past two weeks as traders parsed economic indicators for signs of the impact of Fed tightening, even as Big Tech earnings disappointed.
Fed forecasts released last month showed officials expecting rates to reach 4.4% this year and 4.6% in 2023, suggesting the pace of hikes will slow to 50 basis points in December and then downshift to 25 basis points early next year. Since then, disappointing news on inflation showing core consumer prices rising to a 40-year high of 6.6% in September has led some officials to suggest a higher peak may be needed to cool demand and reduce price pressures.
Fed officials appear divided on the pace of further tightening. Philadelphia Fed President Patrick Harker said officials are likely to raise interest rates to “well above” 4% this year while his Chicago counterpart Charles Evans said overshooting can be costly “and there is great uncertainty about how restrictive policy must actually become.”
A Bloomberg survey of mainly Wall Street economists puts the probability of a recession in the coming year at 60%, up from 50% a month earlier. A classic recession warning is flashing in the US Treasury market. The 10-year note’s yield fell below the three-month bill’s, a rare occurrence that signals investors anticipate dire economic consequences of the Federal Reserve’s campaign against inflation. Inversions of the three-month to 10-year yield curve have heralded past recessions. The curve inverted as much as 0.28 percentage points in March 2020 and became profoundly negative in 2019, 2007, and 2000, all at the end of the Fed tightening cycles.
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A slew of US data on manufacturing, home prices, and consumer confidence have all fallen short of economist estimates, underscoring the toll of Fed tightening. Meanwhile, Federal Reserve officials have sounded a more cautious note, with San Francisco Fed President Mary Daly saying last week that policymakers should start planning for a reduction in the size of interest-rate increases.
“In 17 bear-market rallies since 1970, the S&P 500 rose by an average of 15% over 44 days,” strategists led by David Kostin wrote in a note. The Morgan Stanley strategists expect the S&P 500 to rally to 4,150 points, about a 6% gain from Friday’s close, amid their short-term bullish call. They use 3,700 as their trailing stop loss level. Last week, Wilson said the bear market is likely to end sometime in the first quarter.
Stocks have recovered after hitting their bear-market low earlier this month as speculation grew that the Federal Reserve will slow its aggressive monetary tightening amid a weakening economy. Despite disappointing results from Microsoft Corp. and Google parent Alphabet Inc., the S&P 500 erased earlier losses, rising 0.6% as of 11:50 a.m. in New York. The index has climbed about 8% this month. Yet at times, the persistent pessimism set the stage for a rally as bears were forced to buy back shares to limit losses, a move that added fuel to the upside for big benchmarks. That dynamic appears to be on display on Wednesday, with a basket of most-shorted companies jumping as much as 5%.
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Below are the scenarios from the JPMorgan team on how the S&P 500 could react on Fed day.
- 75 basis point hike and a dovish press conference: A scenario viewed as having the second-highest probability of playing out. “If you saw the Fed give explicit guidance for the December meeting, then that is likely viewed as a dovish outcome.” S&P 500 up 2.5% to 3%
- 75 basis point hike and a hawkish press conference: “This is the most likely outcome with Powell retaining optionality for December and 2023 meetings while emphasizing the current risks to inflation moving higher.” The team also views this as the outcome most expected by bond markets, so says there may not be a significant move in yields that keeps equities from melting down. S&P 500 is down 1% to up 0.5%
A gauge of the dollar’s strength fell to a three-week low last week as traders bet the Federal Reserve will temper the pace of its rate hikes amid signs the world’s biggest economy is starting to slow. While a 75-basis-point hike next week is still fully priced, traders only see a 50% chance of an increase of that size in December, down from 80% last week. “I don’t think we have seen the turning point for the dollar,” said Shimomura, senior portfolio manager in Tokyo. “It won’t probably come until we have a clearer view on how far the Fed will raise rates.”
It’s too soon to write off the dollar’s dominance as the US rate-hike cycle may not be near its peak. But dollar bulls remain undaunted by a hawkish Fed, fears of a global recession and heightened geopolitical tensions in Europe should only bolster demand for the US currency, investors say. “At the moment it is difficult to see kind of what causes the dollar to weaken from here,” said Iain Stealey, international chief investment officer for fixed income at JPMorgan. “The Fed hasn’t hit the terminal rate yet, the US economy looks like it’s probably a bit more resilient than some other economies out there.”
Bullish greenback bets are around double the average over the last five years, according to Bloomberg CFTC non-commercial futures.
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