Fed Preview: Dovish Forward Guidance Not Enough To Save the Market

Though markets are predominantly pricing in a slowdown in rate hikes in December after an expected 75 basis point increase on Wednesday, traders shouldn’t hold their breath for a soft landing, according to analysts. 

Investors seem confident the Federal Reserve is poised to continue rate hikes this week. Futures markets were pricing in an 87.5% chance of a 75 basis point bump Tuesday afternoon in New York as the Federal Open Market Committee kicked off its two-day policy meeting, according to CME Group data.

Just a month ago, markets were split, with 43.5% anticipating a 50 basis point increase and 56.5% calling for 75 basis points. 

“While a 75 basis point hike looks locked in tomorrow, the messaging is what investors are interested in,” Craig Erlam, a senior market analyst at Oanda, said. “Despite inflation remaining at eye-watering levels, there’s a growing belief that the central bank will signal a desire to ease off the brake over the following few meetings starting with a 50 basis point hike in December.”

Equities and cryptos were trading lower Tuesday following the release of an unexpectedly positive jobs report, signaling that the Fed may continue its aggressive policy moves. 

If the Fed does not hint at a December pivot, markets will respond negatively, although not in an extreme way, according to Tom Essaye, founder of Sevens Report Research. 

“The market is overextended in the short term so this outcome, while not any worse than

currently expected, should result in a mild to modest decline in stocks — around 1% at the worst,” Essaye said. “We’d expect growth to continue to lag, while the defensive sectors and value relatively outperform.” 

With persistent inflation, disappointing earnings and yield curves inverting, a recession could be looming. The risks of aggressive tightening may now be greater than a more gradual approach, Erlam said, and the economy has a lot of tightening to absorb if and when rates hit 3.75% to 4% this week. 

“A dovish signal could be an exciting moment for equity investors, one they’ve craved all year, but that doesn’t mean it’ll be plain sailing from here,” Erlam said. “There’s still the economic drop-off and potential global recession to contend with, not to mention a highly uncertain winter in Europe.”

Even if the Fed signals a dovish shift in its forward guidance due out Wednesday, it is still too soon to call the bear cycle over, Essaye said. 

“If the Fed signals 50 bps [basis points] in December, we have to remember that’s not the Fed pivot we need to help mark a bottom, so even if the market gets the dovish outcome it wants, it won’t be an ‘all clear’ on stocks, regardless of any subsequent rally,” Essaye added.

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