Bracing for a Hawkish Fed: Markets Could Sour or Soar

The financial markets are bracing for the Federal Reserve’s May decision on monetary policy. Meanwhile, any expectations for lower rates have all but vanished, and a more hawkish Fed stance is now anticipated. The problem with this is that higher interest rates mathematically bring down bond prices and could cause the bear market in bonds to continue. What’s more, many analysts predict that interest rates, even if maintained at current levels, could spell trouble for stocks.

Fed Signals and Market Concerns

A slew of recent economic indicators and statements from Fed officials signal a hawkish-for-longer approach to monetary policy. A recurring theme involves inflation concerns and a resilient economy. Neither is paving the way for a soft landing nor is the Fed saying, “Mission accomplished.” Instead, using public speeches as its messenger, the Federal Reserve has indicated a strong commitment to fighting inflation, even at the cost of crimping economic growth. Treasury yields, for their part, have resumed their upward climb as past anticipation of lower rates is quickly pricing itself out of market yields.

The reason for the Fed’s significant inflation concern is core PCE (Personal Consumption Expenditures), which is now averaging 2.9% over the past 12 months. The Fed has resolved to bring inflation down to 2%. Simultaneously, it has been consistent in stating that it is ‘data-dependent.’ Since the PCE number is the Fed’s preferred inflation measure, and it is data, and it is overly high, this points to no new easing steps. The notion of persistent inflationary pressure has led the markets to realize that rate cuts aren’t coming soon. If anything, traders might now expect a paltry quarter-point cut late in 2024.

Bond investors have turned bearish on U.S. Treasuries as a result of all these developments. That’s why the 10-year U.S. Treasury yields are hovering around 4.63%, after spending much of the year 20-25 basis points lower. The Treasury options market confirms this sentiment. After hitting a high for the year, it suggests that Fed policy may even include an increase in interest rates.

Potential Market Impact and Stock Market Resilience

Despite the hawkish signals from the Fed and the surge in Treasury yields, some analysts believe that the stock market may be more resilient than it’s given credit for. We see this as investors scrutinize the Fed’s language and actions to gauge the potential impact on equities. While a hawkish Fed could create short-term concern and volatility in the stock market, a strong argument could be made that the Fed’s resolve to fight inflation, the economy’s resilience, and the Fed’s commitment to managing inflation could ultimately benefit stocks. After all, not fighting inflation is inflationary.

Key Takeaway

As the Federal Reserve prepares to announce its decision on interest rates this week, investors and analysts remain divided on the potential impact on the stock market. Some think a hawkish Fed could lead to increased volatility and short-term challenges for equities, while others believe that the market may be overly concerned and that stocks could weather the storm better than expected. Ultimately, the outcome might depend on the Fed’s language and actions, as well as the market’s ability to adapt to changing monetary policy.