(Bloomberg) -- One year to the day after the Federal Reserve launched its biggest rate-hiking campaign in decades, traders are still guessing at the central bank’s next step as fears about the banking system have markets throwing their prior expectations out the window.
Clearly conditions right now are very different than what the Fed was looking at on March 16, 2022. Banks are in danger of failing, stocks are wobbling and recession angst is rising after the collapse of Silicon Valley Bank as well as the troubles at Credit Suisse Group AG and First Republic Bank. This explains the moves in the S&P 500 Index, which soared 9% to start the year but is now up just 1%.
However, there is one glaring similarity to last year: Inflation, despite signs of slowing, remains stubbornly high.
“Inflation is decelerating, but not uniformly, so markets still don’t know if the Fed will actually pause raising rates,” said Louise Goudy Willmering, a partner at wealth-management firm Crewe Advisors. While the current situation is markedly different from the 2008 global financial crisis, “the market has taken on a life of its own as it assigns what is panic at what time.”
Challenging Year
It’s been a tough year for stocks since the Fed kicked off its tightening with rates near zero. The S&P 500 has lost almost 10% over the past 12 months. In 2022, the gauge posted its biggest annual decline since 2008, tumbling 19%. Meanwhile, rising rates hammered the outlook for technology and growth shares, with the Nasdaq 100 Index plunging 33%, also its largest drop since 2008.
All of which makes the Fed’s next policy decision at its meeting on Wednesday, and Chair Jerome Powell’s remarks afterward, a critical moment for the stock market.
The central bank raised rates by a quarter-point at its last meeting to a range of 4.5% to 4.75% — a level last seen in 2007. Swaps traders are leaning toward another hike of that size next week. But they’ve also begun to price in cuts by the Fed, after a peak around May, based on the idea that the central bank doesn’t want to exacerbate any problems at major banks.
In other words, traders believe markets are approaching a key juncture — the end of the Fed’s rate increases. Historically, nailing that timing has delivered double-digit returns for equities investors.
“It took a near banking crisis to get the Fed to pay more attention to the damages it has caused to the economy by raising rates so quickly,” said Jimmy Lee, chief executive of The Wealth Consulting Group, who’s betting the US economy may avoid a recession on the back of a strong consumer. “We may get a silver lining out of this banking situation if the Fed ends up pausing rate hikes – and I think they will stop for now.”
Crewe Advisors’ Willmering is betting on US stocks rising over the long term. But her firm is urging clients to diversify by buying shares of health-care companies as they await further guidance from the Fed.
There’s at least one catch that should give money managers pause: The Fed has never cut rates when the unemployment rate — currently 3.6% after hitting a nearly half-century low at the start of the year — is this low, according to Jim Reid, a market strategist at Deutsche Bank AG.
Still, the camp calling for at least a pause has plenty to lean on. For example, Goldman Sachs Group Inc. raised the odds of a US recession over the next 12 months to 35% in light of all the uncertainty surrounding the banking system.
In addition, the Fed knows that monetary policy has lagging effects. It can take 18 months to two years for tightening policies to materially affect inflation, according to the Atlanta Fed.
For investors, it’s a head-scratching stretch. And the fear is that equities have more room to fall unless the US central bank hits the brakes next week.
“The Fed is in a tough spot,” said Thomas Martin, senior portfolio manager at Globalt Investments. “Stock investors are very focused on what the Fed does given that its mandate is to avoid a financial meltdown, then policymakers can go back and continue to fight inflation. Powell has a chance to send a clear message to markets. Financial stability is now the number one goal.”
©2023 Bloomberg L.P.
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