Here’s why a stop-and-go Fed might rattle U.S. markets

Tuesday’s consumer-price index report for May brought some welcome signs of easing U.S. inflation for investors, along with a more complicated task for the Federal Reserve and Chairman Jerome Powell.

Readings on core CPI gauges, which strip out food and energy to present a purer read on inflation, are still likely too hot for policy makers who have a 2% inflation objective. The monthly core rate rose by 0.4% in May for the third month in a row, while the increase in the past 12 months came in at 5.3%. This raises the possibility that once investors’ enthusiasm over Tuesday’s data wears off, U.S. markets could be rattled once again if the Fed resumes hiking after taking no action on Wednesday.

Investors have been eager to see an end to the Fed’s most aggressive rate-hike campaign of the past four decades, even though the market-implied likelihood of the central bank delivering a hike in July has remained above 50% since last week. Goldman Sachs Asset Management expects the Fed “to deliver a hawkish pause [on Wednesday] and to highlight the possibility of following a similar path to the Reserve Bank of Australia and the Bank of Canada,” which both resumed hiking after taking their own pauses, said Alexandra Wilson-Elizondo, deputy chief investment officer of multi-asset solutions.

“The Fed will struggle to sound credibly hawkish if it pauses on Wednesday, given the fact that policy makers have been data dependent,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities in New York. “The data continues to suggest the labor market is still hot and that core inflation is still very strong. It will be difficult for the Fed to communicate a pause and restart rate hikes later on, and will be a very complicated message to send to investors.”

TD made an out-of-consensus call for a final 25-basis-point rate hike to be delivered on Wednesday, even though fed-funds futures traders see a 97.6% chance of no action by the Fed that would leave its main interest-rate target between 5%-5.25%.

“We think Wednesday’s decision is a lot closer than the market is pricing in,” Goldberg said, and investors are likely to cheer a Fed pause tomorrow “even if the Fed signals more hikes are plausible” down the road.

As of Tuesday afternoon, all three major U.S. stock indexes
DJIA,
+0.47%

SPX,
+0.66%

COMP,
+0.65%
were higher after May’s inflation data reinforced investors’ expectations that the Fed will take no action on Wednesday. Meanwhile, Treasury yields were mixed: the policy-sensitive 2-year rate
TMUBMUSD02Y,
4.679%
jumped to 4.68%, leading an advance in most rates through the 30-year maturity
TMUBMUSD30Y,
3.930%,
while 1-month through 6-month T-bill rates all dropped.

Less than a week ago, U.S. investors were rattled by a surprise quarter-of-a-percentage-point rate hike from the Bank of Canada after pauses in March and April, which reminded many in financial markets that skipping rate increases doesn’t necessarily mean an end to monetary tightening. After that decision last Wednesday, the S&P 500 and Nasdaq Composite faltered, falling 0.4% and 1.3% respectively, with the former missing the threshold that would have marked an exit from a bear market. (The S&P 500 exited its longest bear market since 1948 the next day.)

The Bank of Canada’s decision came a day after the Reserve Bank of Australia delivered its second straight quarter-point rate hike after having paused in April.

The possibility of the Fed also being forced to resume hiking after skipping one or two meetings is a “very likely scenario,” said Jeffrey Cleveland, director and chief economist at Payden & Rygel, a Los Angeles-based investment management firm that oversees almost $150 billion in assets. Payden & Rygel expects the Fed to skip action on Wednesday and Cleveland said policy makers won’t have enough data on hand by their July 25-26 meeting to know whether core inflation is “definitely slowing.”

If the Fed follows the Bank of Canada and RBA with a stop-and-go policy, the first impact would be on shorter-dated Treasury yields, namely the 2-year yield which could go back to 5% or higher, Cleveland told MarketWatch. Short-term rates could rise faster than their long-term counterparts, or what’s known as a bear flattening of the Treasury curve, as a higher-for-longer Fed gets priced in, he said.

Meanwhile, the outcome for stocks would be more “tricky,” according to Cleveland: If inflation is sticky because the economy is doing well, “stocks might do OK.” But if sticky inflation is accompanied by faltering growth in a stagflation-like environment, “that would be gruesome for stocks,” he said.

“I worry that if this moves to September and we still have 0.4% core CPI on a monthly basis, the Fed will be back into hiking mode,” Cleveland said. “It will be more jarring for the market. If they don’t hike and don’t sound hawkish enough on Wednesday, some will be convinced that the Fed is done and that could hold sway over markets until another one or two CPI reports. My big fear is if they do pause or skip and inflation doesn’t cool off, they have to restart — which opens the door to, ‘Do we need to go to 6%’ with interest rates? Or ‘what’s really going to do trick?’”