Potential Impact of Federal Reserve Actions on Stock Market Performance

Potential Impact of Federal Reserve Actions on Stock Market Performance

The stock market hasn’t found a reason to drop all that much of late—but the Federal Reserve could easily give it one.

Nothing has been able to kill this bull market. Even this past week, which featured hotter-than-expected consumer and producer price indexes and weaker-than-expected retail sales, didn’t do all that much to dampen the enthusiasm.

As of midday Friday, the

S&P 500 index

had declined just 0.2% for the week, while the

Dow Jones Industrial Average

gained 0.1% and the

Nasdaq Composite

fell 0.7%.

While stocks didn’t freak out about inflation, other financial markets certainly reacted. The federal-funds futures market reflects just a 58% chance that the Fed will cut interest rates at least once—by July. At the end of December, there was a 75% chance of at least one cut by March.

What’s more, the two-year Treasury yield, a barometer for expectations about the fed-funds rate, is up more than 30 basis points for the year, to 4.7%. The last time it was at this level, in early December, the S&P 500 was 11% lower. (A basis point is 1/100th of a percentage point.)

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The stock market is ignoring these troublesome signals—and the Fed may have to provide a wake-up call at its monetary policy meeting, which ends this coming Wednesday. Almost no one expects the Fed to actually do anything—there’s a 99% chance it leaves rates right where they are—but it’s the signals about the future investors should worry about. The current “dot plot” suggests three cuts this year, but it’s possible that could change.

“The Fed’s policy meeting next week could be a highly consequential one,” writes Thierry Wizman, global foreign exchange and rates strategist at Macquarie, who notes it could “formally extend the wait-and-see period.”

If the Fed officially dashes hopes of rate cuts this year, the market would be, well, unthrilled. “We expect price action to be quite volatile as we believe that investors are placing too much emphasis on the timing and magnitude of potential Fed rate cuts, with market expectations and Fed speak seemingly at odds at the current moment,” writes Brian Belski, chief investment strategist at BMO Capital Markets. “We do not view the current pace of U.S. stock market gains as sustainable.”

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The counterargument is that, under the surface, the market is showing signs that it can remain hot. More than 60% of stocks on the S&P 500 have notched gains this year, according to FactSet, so the index isn’t so reliant on a handful of Big Tech names to stay afloat. With inflation still pretty hot and commodity prices up this past week, the index’s energy and materials sectors gained. Even consumer staples, which broadly have strong pricing power, are flat for the week, outperforming the index.

Will the Fed finally spark a rotation that causes the market to sink? We’re about to find out.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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