The Fed's meeting set-up for today is very similar to the one that existed before the meeting in July. Investors bet on the Federal Reserve signaling a less hawkish outlook for policy. The S&P 500 rose strongly from its bear-market bottoms before each meeting.
In July, the bulls were right. Federal Reserve chief Jerome Powell suspended his guidance and appeared to suggest a moderated pace of tightening in the future. S&P 500 soared up to 18% since the June 16 lows. This marked an end to a bear-market. The 10-year Treasury yield fell to close to 2.5%, and the 30-year fixed rate mortgage dropped to 5%.
The Fed wants to see an entirely different result this time. Powell learned from the fact that this summer's rally, which was fueled by expectations of a Fed U turn to rate cuts in 2020, reversed most of the tighter financial condition created by nearly six months rate hikes. This allowed for the tightening of the job market and an acceleration in service sector inflation.
The markets fully expect the Fed to raise rates by 75 basis points on Wednesday. This will be their fourth super-sized hike. Investors are hoping Powell will hint at a possible downshift of no more than fifty basis points during the Fed's meeting on Dec. 13-14 and an upcoming pause in 2023.
These hopes will likely be dashed. Powell is being very cautious in his discussion of Fed policy after his July 27 press conference ignited the S&P500. Powell stated that his speech in Jackson Hole on August 26 would be shorter and more focused, with a clearer message.
The Federal Reserve's message was clear: To avoid a bout of high inflation like the 1970s, it will maintain high interest rates for a long period. "We'll keep working until we feel confident that the job has been done."
Powell's unwavering hawkishness and his stiff-arming of talk about a quick Fed turnaround succeeded in tightening the financial conditions. The yield on the 10-year Treasury note climbed above 4%, and that of the 30-year fixed-rate mortgage was 7%.
Powell could accentuate the negative now that the S&P 500 is back in rally mode despite a modest pullback on the stock market Wednesday following the declines of Monday and Tuesday. Aichi Amesiya, Rob Dent and Nomura economists wrote that committing to a slower rate hike pace could lead to a greater risk-on rally. This would undo the Fed's attempts to tighten financial condition.
In order to counteract this possibility, they wrote that "we see a risk that Powell mentions that the incoming inflation data so far does not support an downshift in rate increases." The Fed is also not ruling out the possibility that Powell will mention a 5% rate as the Fed's maximum rate for the current cycle.
Powell is still limited in how aggressive he can be. This is partly because some members of the Fed's policy committee, such as vice chair Lael brainard, have expressed discomfort with 75-basis point hikes that are made rapidly.
Powell may not reveal his intentions until the December meeting, even if he is inclined to slow down the rate of hikes. The Fed will be updating their projections of rates for 2023 and the future at its final meeting. Rate hikes that are slower, combined with projections of a hawkish outlook for rates, may not be good news for bulls.
It's unclear whether Powell can derail the current rally unless he makes a big surprise, like Powell mentioning that 5% is the rate. Investors see the glass as half-full for now. Rent inflation is on the decline and inflationary indicators are easing. The wage growth is slowing down, and it's likely that we will see a weaker October jobs report. After hiking so much and so quickly, it's very likely that the Fed will stop rate hikes during the first quarter 2023.
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