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How a hawkish Fed could kill a baby bull-market rally in U.S. stocks


It’s the notion, which has grown popular that the Federal Reserve could suggest it may need to raise interest rates further in coming months, even if it refrains from raising rates again when its two-day policy meeting ends on Wednesday.

Some on Wall Street are concerned that stocks could slump if an uncomfortably strong reading on May inflation, due this coming Tuesday as the Fed’s policy meeting starts, means the central bank will feel the need to tighten monetary policy more aggressively.

The May consumer price index is forecast to rise 4.0% for the year, down from a rise of 4.9%, while the core index, excluding food and energy prices, is seen easing to a rise of 5.3% from 5.5%.

However, signs that the economy is weakening and inflation has continued to fade could allow the Fed to justify skipping a rate hike in June, and signal that a hike in July could be the last one for the cycle.

“Softening US data should support calls that a June skip could eventually turn into a July pause. Next week, most of the data is expected to remain weak or little changed: retail sales could be flat m/m, the Fed regional surveys should remain in negative territory, and consumer sentiment will waver,” said Craig Erlam, senior market analyst at OANDA, in emailed commentary.

See: The Fed’s crystal ball on inflation appears off the mark again. Here’s comes another fix.

Despite recent interest rate rises by the Fed, stocks have seen strong gains since last October, with the S&P 500 index up more than 20% from its Oct. 12 closing low, according to FactSet. The gains have taken the S&P 500
SPX,
+0.11%

out of bear-market territory for the first time in a year. The index has climbed 12% so far in 2023, reversing some of its 19.4% decline from 2022, its biggest calendar-year drop since 2008, according to Dow Jones Market Data.

However, its gains have been largely driven by a handful of megacap technology stocks, along with a spate of other technology and semiconductor names, data show. Expectations that the Fed will keep its policy interest rate higher for longer could finally bring some of these market leaders back down to Earth, creating an opportunity for small-cap and value stocks to extend an incipient streak of outperformance.

The so-called “Mega-cap eight” stocks — a group that includes both classes of Alphabet Inc. stock
GOOG,
+0.16%

GOOGL,
+0.07%
,
Microsoft Corp.
MSFT,
+0.47%
,
Tesla Inc.
TSLA,
+4.06%
,
Microsoft Corp.
MSFT,
+0.47%
,
Netflix Inc.
NFLX,
+2.60%
,
Nvidia Corp.
NVDA,
+0.68%
,
Meta Platforms Inc.
META,
+0.14%

— have driven nearly all of the S&P 500’s gains this year, according to Ed Yardeni, president of Yardeni Research, who included his anlaysis in a note to clients.

But other areas of the market have started to outperform the tech sector. The Russell 2000
RUT,
-0.80%
,
a gauge of small-cap stocks in the U.S., has risen more than 6.6% since the beginning of June, according to FactSet data. The Russell 1000 Value Index has also gained nearly 3.7% in that time.

The tech-heavy Nasdaq Composite has risen 2.9% in June, but since Jan. 1, it’s up 26.7%, having recouped much of its losses from 2022.

The changing character of the market became even more acute on Wednesday when the Bank of Canada delivered a surprise interest-rate hike, ending a four-month pause. It followed a similar move by the Reserve Bank of Australia. Partly as a result, U.S. Treasury yields rose and tech-heavy stocks tumbled, with the Nasdaq falling 1.3%, its biggest drop since April 25, according to FactSet.

Consequences of a ‘hawkish pause’

However, if the Fed delivers delivers a hawkish surprise of its own, perhaps even going so far as to hike rates despite its usual protocol of signaling its moves clearly in advance, stocks could be vulnerable to a sharp pullback.

Miller Tabak + Co.’s Chief Market Strategist Matt Maley told MarketWatch that the Cboe Volatility Index falling back below 15
VIX,
+1.32%

for the first time since before the arrival of COVID-19 is a sign that the market has grown complacent, even as investors once again rush to scoop up Vix calls on the cheap.

Others pointed out that signs of higher rates to come could send markets back to the bad old days of 2022.

“If the Fed signals that rates will be going up again, the market playbook could read more like 2022 than what we have seen so far in 2023,” said Will Rhind, the founder and CEO of GraniteShares, during a phone interview with MarketWatch.

While the Fed has a history of closely telegraphing its moves to the markets in advance, Tuesday’s last-minute inflation report could complicate things.

As a result, Rhind said investors are likely underestimating the chances of a hike next week. Fed funds futures currently see a roughly 70% probability that the central bank will refrain from raising rates this week after 10 consecutive increases.

He’s not alone. Leslie Falconio, chief investment officer at UBS Global Wealth Management, summed up Wall Street’s concerns in commentary emailed to clients.

“We believe another rate hike is on the table, and that the CPI release on 13 June, a day before the Fed decision, will be decisive. In our view, another hike will not have a material impact on the pace of economic growth,” Falconio said.

What would it look like?

The Fed may almost certainly need to raise its published interest-rate projections via its closely watched “dot plot” if it hopes to signal that at least one more hike is to come, said Patrick Saner, head of macro strategy at the Swiss Re Institute.

“If the Fed skips but wanted to avoid the impression of the hiking cycle being done, it would need to include a revision of the dot plot. They could justify that with a more resilient GDP forecast and a higher inflation outlook. So I think it’s the dots and then the statement that will be in focus,” Saner said during a phone interview.

Whatever the Fed does or says, it will ultimately be viewed through the lens of economic data that’s due out next week in including the May consumer price index due Tuesday.

Other data due includes the May producer price index on Wednesday, May retail sales on Thursday, and readings on consumer sentiment from the University of Michigan on Friday.

See also: Puzzled by the ebb and flow of recession worries? Then the MarketWatch weekly recession worry gauge is for you.



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