September Fed Meeting Outcome To Have Limited Impact On Markets (SPX)

The U.S. Federal Reserve is due to announce its decision following a two-day monetary policy meeting which ends on September 20. For an event that is usually surrounded by intense anticipation and debate among economists and traders, the upcoming meeting appears to be generating much less attention and discussion than before. This apparent state of calm and lack of speculation surrounding the Fed’s decision is worth mentioning. Because we think it captures the reality that stagflation alarmists and perma bears have been denying: that the Fed’s job is done.

Job Well Done

Based on the Fed’s dual mandate of pursuing maximum employment and price stability, it should be quite clear that the Fed is doing a great job. As the chart above shows, since September 2022, both the Core Consumer Price Index (Core CPI) and the Core Personal Consumption Expenditure Price Index (Core PCE) have been on a downward trend.

Meanwhile, labour market data in August continue to indicate that demand for workers is cooling and previous concerns of wage-price inflationary pressures are largely unwarranted. As the accompanying chart shows, monthly job growth and average monthly pay have both moderated substantially in recent months.

Just like how policymakers look at a basket of goods and services instead of narrowly focusing on a single item to gauge inflationary pressures, job market data should also be interpreted broadly by looking at multiple industries. In this respect, the vast majority of job gains in recent months have been narrowly concentrated in a handful of sectors including education & health and leisure and hospitality. Hence, the FOMC should feel at ease that recent job gains should not translate into broader wage-price inflationary pressures.

Perma Bears In Denial

Of course, the perma bears will argue that inflation is still well above the Fed’s 2% target, that the yield curve remains deeply inverted, or that the lagged effects of monetary tightening have yet to fully hit the economy. Some at the International Monetary Fund even argued that the U.S. unemployment rate will have to reach as high as 7.5% in order to tame inflation. Based on these arguments and many others, they draw the conclusion that an economic crisis is inevitable.

Pessimistic predictions naturally attract the attention of active traders and fearful investors who place a much greater emphasis on timing short-term market swings. For the financial media industry, maximising viewership means capitalizing on this bias and loading the headlines with pessimistic headlines.

It is important, however, to differentiate between mere warnings and reality. Warning that there are existing risks and headwinds to economic growth is one thing, but saying that an economic crisis is inevitable is another. In fact, we struggle to recall if there was ever a time when the equity market and economy were free from risks and uncertainties. All kinds of risks exist in the financial markets at any point in time. What matters for most investors, however, is not whether risks of an economic crisis exist, but how likely those risks are likely to materialize. For long-term investors, the potential duration and magnitude of a potential economic crisis also matter more than mere speculation over a crisis that may or may not materialize. That is why institutional investors rarely dump their equity exposure based on some doomsday prediction.

The Equity Market Is Optimistic For Good Reasons

The age-old saying on Wall Street that the market is always right comes to mind. And judging from the performance of the S&P 500 Index (SPX) to date, the equity market certainly seems unbothered by the risk of an impending crisis. Indeed, the S&P 500 Index has climbed a wall of worry since October 2022 when the market bottomed out. It was a massive wall too, considering that the market had to contend with predictions for stagflation, property market crash, widespread corporate defaults, bank runs, and geopolitical risks.

In comparison to the many risks and crisis scenarios that the equity market had to overcome thus far, the Fed’s decision on whether to keep its policy rate on hold at 5.25 to 5.5% may seem like a relatively benign event. Expectations for either scenario of the Fed keeping its policy rate on hold, or implementing a final hike, should have already been priced in by now.

Financial markets are currently pricing a near certainty that the Fed will keep its policy rate on hold on Wednesday, according to CME’s FedWatch tool. Besides, a 25 basis points hike at this point will have a smaller impact on the economy than previous hikes because most of the monetary tightening had already been done.

The Federal Open Markets Committee (FOMC) is also due to release its quarterly Summary of Economic Projections and the “dot plot”, which provides a glimpse into the committee’s expectations for interest rates in the coming quarters. As the above chart shows, even the “dot plot” is clearly signalling the FOMC’s sentiment that the job is done and that rate cuts are ahead.

If the “dot plot” hasn’t changed that much in recent months, then it shouldn’t come as a surprise that the SPX is also not heading higher, nor suffering from a panic sell-off. We interpret this consolidation pattern for the SPX since July as an indication that the market remains cautious and is waiting for the FOMC’s green light on rate cuts before advancing further. What this means is that we expect the upcoming FOMC decision is likely to have a limited impact on the SPX.

FOMC May Drop Its Balancing Act

In an earlier article published in April, we discussed the FOMC’s challenging task of managing market sentiment as part of monetary policy. We argued that the financial media’s favourite phrase “still well above the Fed’s 2% target”, is essentially a moot point and that the FOMC will know its job is done, well before Core PCE hits 2%. But the real problem is that the FOMC can’t declare the end of monetary tightening yet because it has to manage market sentiment.

Now that the FOMC has reached its intended peak rate as communicated by its “dot plot” and has successfully kept financial conditions tight by keeping the market guessing on its next move in previous meetings, we think the FOMC may soon drop its balancing act. It is anyone’s guess as to when exactly the FOMC will feel comfortable enough with cooling inflation to begin hinting at rate cuts. And the market is just waiting for the FOMC’s green light to go shopping for risky assets. We believe we are much closer to that point than most people think.

Recent economic data clearly indicate to us that the U.S. economy is cooling, and we are beginning to see incipient risks of the FOMC being behind the curve in normalising monetary policy. At least for now, it seems that the U.S. consumer is resilient enough to support the economy given a strong and resilient labour market. From our perspective, the risk of keeping interest rates too high for too long is not only unnecessary given that core inflation is already within reach of the FOMC’s 2% target, but risks throwing the economy into a real crisis.

The evidence seems quite clear to us that the fight against inflation is won, but we have no idea what the FOMC truly has in mind. Whether the green light will come on Wednesday or in November, it is ultimately the FOMC’s call on communicating monetary policy. We can only hope that they are not friends with perma bears betting on a hard landing.

For now, we remain hopeful that the FOMC will start hinting at a policy pivot and we maintain our “Strong Buy” rating on the SPX with a 4,600 target by the end of the year. Should the FOMC hint at rate cuts on Wednesday, we would consider upgrading our SPX target to 4,800 to 5,000 by the end of the year.