Wall Street is calling it a "hawkish pause" or a "hawkish skip."
It is the notion that the Federal Reserve could deliver a hawkish jolt to markets even if it refrains from raising rates when its two-day policy meeting ends on Wednesday.
There are concerns that such an outcome could spark a turnaround in U.S. stocks, especially if an uncomfortably strong reading on May inflation -- due this coming Tuesday just as the Fed's policy meeting is slated to begin -- pushes the central bank toward something even more extreme, like delivering a rate increase on Wednesday despite intimating that it plans to abstain.
The May consumer-price index is forecast to rise 4.0% for the year, down from a rise of 4.9%, while the core index, excluding food and energy prices, is seen easing to a rise of 5.3% from 5.5%.
On the other hand, signs that the economy has weakened and inflation has continued to fade would help the Fed to justify skipping a rate increase in June -- as several senior officials have suggested it will -- while signaling that a potential hike at its following meeting in July could be the final increase for the cycle.
"Softening U.S. data should support calls that a June skip could eventually turn into a July pause. Next week, most of the data is expected to remain weak or little changed: retail sales could be flat m/m, the Fed regional surveys should remain in negative territory, and consumer sentiment will waver," said Craig Erlam, senior market analyst at OANDA, in emailed commentary.
Wednesday's meeting comes at a critical time for the market. U.S. stocks have powered ahead for more than six months, with the S&P 500 having risen more than 20% off its Oct. 12 closing low, according to FactSet. Just this past week, the index exited bear-market territory for the first time in a year.
The index is up 12% so far in 2023, reversing some of its 19.4% decline from 2022, its biggest calendar-year drop since 2008, according to Dow Jones Market Data.
So far this year, highflying tech stocks have helped to paper over weakness in other areas of the market. This has started to change over the past two weeks, as small-cap and value-stocks have lurched suddenly higher, but there are fears that the Fed could hurt the most interest-rate sensitive technology names if Chairman Jerome Powell hints at rates rising higher than investors presently anticipate.
The so-called "Megacap eight" stocks -- a group that includes both classes of Alphabet Inc. stock $(GOOGL)$(GOOGL), Microsoft Corp. $(MSFT)$, Tesla Inc. $(TSLA)$, Microsoft Corp. $(MSFT.UK)$, Netflix Inc. $(NFLX)$, Nvidia Corp. $(NVDA)$, Meta Platforms Inc. $(META)$ -- have driven nearly all of the S&P 500's gains this year, according to Ed Yardeni, president of Yardeni Research, who included his analysis in a note to clients.
But since the beginning of June, the Russell 2000 , a gauge of small-cap stocks in the U.S., has risen more than 6.6%, according to FactSet data. The Russell 1000 Value Index has also gained nearly 3.7% in that time. During this period, both have outperformed the tech-heavy Nasdaq Composite , although the Nasdaq remains the market leader, having risen 26.7% since Jan. 1.
Concerns about the Fed's plans intensified this week after the Bank of Canada delivered a surprise interest-rate hike, ending a four-month pause. The BOC's decision followed a similar move by the Reserve Bank of Australia, and partly as a result, U.S. Treasury yields rose and tech-heavy stocks tumbled, with the Nasdaq logging its biggest drop since April 25, according to FactSet.
While small-caps held up amid the chaos, the reaction stoked fears that something similar might be in store for markets when the Fed delivers its latest decision on interest rates Wednesday.
Consequences of a 'hawkish pause'
Stocks could be in for more turbulence if the Fed signals it plans to follow the BOC and RBA with a hawkish surprise of its own. And it wouldn't necessarily need to hike rates to pull this off, market strategists said.
Emerging signs of complacency in the market could complicate its reaction. That the Cboe Volatility Index has fallen back below 15 for the first time since before the arrival of COVID-19 is one such sign that investors aren't worried enough about a potential selloff, said Miller Tabak + Co.'s Chief Market Strategist Matt Maley.
Another analyst likened the potential fallout from a hawkish Fed to the bad old days of 2022.
"If the Fed signals that rates will be going up again, the market playbook could read more like 2022 than what we have seen so far in 2023," said Will Rhind, the founder and CEO of GraniteShares, during a phone interview with MarketWatch.
Perhaps the biggest wild card is Tuesday's inflation report. If the numbers come in hot, Powell and his peers could face pressure to hike rates without priming the market first.
For this reason, Rhind believes investors are underestimating the likelihood of a hike next week, even as Fed funds futures currently see a roughly 70% probability that the central bank will stand pat, according to the CME's FedWatch tool.
And Rhind isn't the only one. Leslie Falconio, chief investment officer at UBS Global Wealth Management, says the Tuesday inflation report could be a make-or-break moment for markets, summing up fears expressed elsewhere on Wall Street in a recent note to clients.
"We believe another rate increase is on the table, and that the CPI release on 13 June, a day before the Fed decision, will be decisive. In our view, another hike won't have a material impact on the pace of economic growth," Falconio said.
What should investors watch out for?
Assuming the Fed does forego a hike in June, there are a few key tells that investors should watch for to determine whether a "hawkish pause" is under way.
Perhaps the most important will be how the Fed handles changes to its closely watched "dot plot." A modestly higher median dot would send an unmistakable signal to the market that the Fed will continue with its campaign of tightening monetary policy, perhaps to the detriment of the market, said Patrick Saner, head of macro strategy at the Swiss Re Institute.
"If the Fed skips but wanted to avoid the impression of the hiking cycle being done, it would need to include a revision of the dot plot. They could justify that with a more resilient GDP forecast and a higher inflation outlook. So I think it is the dots and then the statement that will be in focus," Saner said during a phone interview with MarketWatch.
Beyond that, whatever the Fed does or says will likely be viewed through the lens of economic data that is due out next week. In addition to the Tuesday inflation report, a report on May retail sales is due out Thursday, and a on consumer sentiment from the University of Michigan will land on Friday. All these data points could influence investors' impressions of the state of the U.S. economy, and their expectations for how the Fed will behave as a result.
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