Federal Reserve Meeting: Brace For A Splash Of Cold Water For Dow Jones Rally

The Dow Jones had rallied ahead of the Federal Reserve meeting on hopes for smaller rate hikes, but it may be too early for a pivot.

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May 14, 2023 • 5 min read

The Federal Reserve's meeting wrap-up today looks like it will be a positive for the Dow Jones Industrial Average to continue its recent rally. The stock market's reaction to the Fed's announcements on Wednesday will depend on how Jerome Powell responds about the September meeting, which is still two months away.

Gas and other commodities are now cheaper, and the inflation rate appears to have peaked. A slew of unexpectedly poor economic data is now piling up. If the White House's denials of a recession are any indication, Thursday morning's release of GDP could feature two consecutive quarters with negative growth. In this context, it seems reasonable to expect the Fed to moderate its rate hike pace in September by a half-point.

According to CME Group’s FedWatch, market pricing indicates that there is a 50% chance of a third consecutive hike of 75 basis point on September 21. Fed guidance that points to a half-point increase would be a policy more lenient than expected and should keep investors' rally cap on.

What could -- and likely will -- go wrong if you bet on a sustained rise in the stock market with an aid from this week’s Fed meeting.

The Fed is not concerned about cushioning an economy's landing at the moment because inflation and unemployment are still too high. Fed officials also always take into account how the markets might react to changes in monetary policy. They would probably consider a Dow Jones rise premature at this time, as it would be in opposition to their efforts of cooling demand through tighter financial conditions. They may be careful not to give any reason for investors to feel optimistic in the near future.

Bill Ackman of Pershing Square, the founder of Pershing Capital Management, described the Fed and investor's dilemma on Twitter as follows: "The more that the market believes the Fed will reverse course, the less effective it will be to moderate inflation and the more rates the Fed will need to raise."

Wall Street strategists are increasingly expecting the Federal Reserve will slow down its rate increases. The Fed appears to be halting rate increases as slow growth becomes a recession. Rate cuts may be considered by the spring of 2023. Their thesis is heavily influenced by the recent rally of the dollar against foreign currencies. This has already led to tighter financial terms. The Fed's maximum interest rate ceiling may be lowered by the strong dollar in this cycle.

The Fed could surprise us with a completely different type of pivot. Powell has recently emphasized the importance of inflation in general, which includes volatile food and energy costs, to consumers. It makes sense because workers will be more motivated to demand higher pay if they see their grocery and gas bills increase. These big wage increases may force companies to increase prices to customers in order to offset the inflationary effects of labor.

Powell could shift his focus from the gas price surge to another component of inflation which has not yet shown any progress. The CPI report for June showed that prices for nonenergy categories such as rent, medical care and transportation, which account for 57% household budgets, rose 5.5% compared to a year earlier, the highest rate of inflation since 1991.

This type of inflation is considered to be more sticky, as it is less susceptible to fluctuations in supply and more closely tied to wage growth. Powell said the Fed must see inflation and inflation pressures falling in a convincing manner. The persistent services inflation is a sign that there's still a lot of work to do.

The Federal Reserve is likely to review Thursday's GDP before making any policy decisions on Wednesday. Won't consecutive quarters of negative growth in the GDP put pressure on Fed to slow rate hikes?

The Fed could make a good argument that the high inflation rate is why real growth is negative. Walmart's profit warning (WMT) on Monday hinted at something similar. The company said comparable sales growth was higher than expected.

Powell may say that the only way to turn nominal spending increases into actual ones is to bring down inflation.

Even the Fed's unlikely soft-landing forecasts released in June envisaged a rise to 4,1%. Now, it stands at 3,6%, near the lowest level in a half century. The Fed views higher unemployment as a necessary part of tackling inflation and not something to be avoided.

Also, there may be some discussion about whether or not the Fed's main interest rate is in neutral territory. The Fed's key interest rate is expected to increase to a range between 2.25%-2.5%. The policymakers think the neutral long-term rate of interest will be around 2.4%. This assumes that inflation will return to its target. The Fed's benchmark interest rate, which is below inflation in real terms, is still considered accommodative as long as it is negative.

The idea that the Fed has gained credibility in combating inflation by making consecutive 75-basis-point hikes is key to a bullish turn. If the Fed isn't as concerned about expectations of elevated inflation becoming entrenched in the market, it should be able to adjust to a moderate rate and hike as necessary.

It's still probably too early for the Fed even to relax its guard. There are so many factors that the Fed cannot control in the biggest inflation outbreak since the 1980s. This includes everything from Russia’s invasion of Ukraine, to shutdowns related to pandemics. The policymakers will not assume that the tide has finally turned.

Powell also noted that the disinflationary factors of recent decades are pushing in the opposite direction. The most notable factors are the demographics of the labor force and globalization.

Following Walmart's warning on Monday night, the Dow Jones dropped 0.7% on Tuesday. The Dow Jones has risen 6.3% since its closing low on June 17. This cut its loss from its all-time high closing on Jan. 4, to only 13.7%. The S&P 500, despite its 1.2% decline on Tuesday, has recovered 6.9% of the losses it suffered and is now 18.25% away from its all-time high. Although the Nasdaq fell 1.9% in one session, it has recovered 8.6%, and is still 28% below its previous high.

After spiking to close to 3.5 percent, the yield on 10-year Treasury bonds has now fallen. Investors expect a further decline amid Federal Reserve tightening that will eventually lead to rate cuts.

It only took a 20% decline in the market to get the Fed's program of rate increases and balance sheet tightening to be stopped. In the fall of 2019 the Fed had cut rates and purchased more assets. At the time, inflation was below target and not at a record high.

Dow Jones, among other major indices, has broken above its 50-day line for the first since April. This reflects an optimistic view of a Fed pivot. However, the current uptrends have been under pressure. To stay informed about the current market trends and how they affect your trading decisions, read IBD’s The Big Picture daily column.

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