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A 25 basis point rise in the fed-funds rate is pretty much baked into financial markets ahead of Wednesday’s Federal Reserve policy decision, but specific language in the central bank’s closely watched policy statement will likely determine the immediate reaction.
When the Fed announces the rate decision at 2 p.m. Eastern, investor eyes — and trader algorithms — will likely look to language providing so-called forward guidance on further interest rate moves.
The Fed has “clearly guided” the market toward a 25 basis point, or quarter of a percentage point, hike, said Tom Essaye, founder of Sevens Report Research, in a Tuesday.
“The forward guidance, however, is a bit less certain,” he said, but noted that investors largely expect no changes to this sentence, which appeared in the third paragraph of the June statement: “In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
Translated into plain English, that means the Fed may raise rates again in the future, but that there’s no guarantee, Essaye said.
If repeated, Essaye wrote, the language probably wouldn’t change the minds of bulls who believe a Wednesday rate hike will be the last in a series that has taken the fed-funds rate from near zero in March of last year to above 5%.
Since that’s what the bulls already believe, it might help solidify the stock market’s year-to-date gains but likely wouldn’t trigger a big rally, Essaye said. The U.S. dollar would likely see a modest decline given its recent bounce, while Treasury yields should also fall, with commodities and gold capable of a modest rally.
See: It’s the ‘late-day selloff’ in stocks that characterizes Fed days under Powell
What would it take send the bulls scurrying for cover? A very unlikely, but not totally impossible, half percentage point rate hike would provide a jolt, Essaye said. When it comes to language, any tweaks that signal a further rate increase is a certainty would have the potential to rattle investors.
A selloff for stocks would likely ensue if the Fed were to revert to the language used in its March statement, when it prefaced its discussion of forward guidance with the phrase, “In determining the extent of future increases…” That would effectively tell market participants that another rate increase is on the way.
“Markets simply do not believe the Fed will hike twice more,” despite the Fed’s dot plot forecast showing that’s what individual policy makers expect, Essaye wrote.
Preview: Everyone thinks the Fed’s rate hike this week will be the final one — except the Fed
In that scenario, stocks would likely see a broad selloff, declining more than 1% with defensive sectors and megacap tech stocks outperforming, though all 11 sector-tracking SPDR ETFs would likely decline, he said. Cyclical sectors and small caps would likely underperform, while the dollar would see a strong rally, Treasury yields would rise and commodities would likely sell off.
And the unlikeliest scenario would see the Fed either hold rates steady for a second month on Wednesday, or deliver forward guidance that indicates hikes are likely at an end, Essaye said.
That would likely see stocks jump by more than 1%, putting the 4,800 level in sight for the S&P 500, with gains led by cyclicals and value on growing expectations for a “no-landing” scenario that sees the economy avert recession, Essaye said. The dollar would likely fall, perhaps sending the ICE U.S. Dollar Index
DXY,
back below 100; Treasury yields would plunge and commodities would jump, with gold
GC00,
topping the $2,000-an-ounce threshold.
On Tuesday stocks were extending a rally that’s seen the S&P 500
SPX,
climb back to within around 5% of its record closing high of 4,796.56 set on Jan. 3, 2022, while the Dow Jones Industrial Average
DJIA,
is less than 4% from its record finish set on Jan. 4, 2022. The S&P 500 has rallied more than 19% so far in 2023, while the Dow has gained over 7%.
Read: Stocks are making a run for record territory. Will the Fed end its rate hikes anyway?
The bottom line is that the market, heading into the decision, is essentially saying the Fed is bluffing on two more rate increases in 2023, he said. And as long as the statement doesn’t lead markets to think another hike is substantially more likely than already expected, the market reaction is likely to be muted.
See: Dow Theory signals bull market in U.S. stocks has room to run: analysts
