Investors are largely anticipating that the Fed will hike its policy rate on Wednesday, but that's not the only thing they'll be watching
The stock market has stumbled in September amid higher bond yields.
Investors are largely anticipating the Federal Reserve will raise its benchmark interest rate on Wednesday, but the prospect of higher borrowing costs isn't the only thing inspiring angst on Wall Street.
As the Fed's upcoming press conference begins, and the latest batch of economic forecasts from the central bank are released, investors will increasingly focus on whether the hiking cycle that is expected to begin on Wednesday will be a short-lived adjustment featuring just one or two moves, or a more prolonged hiking cycle with potentially greater ramifications for markets.
At this point, markets risk having a bad reaction if the Fed surprises investors by not lifting its policy rate, Michael Rosen, chief investment officer at Angeles Investment Advisors, told MarketWatch in an interview. In his view, U.S. stocks can absorb a rate hike.
Investors in the stock and bond markets have been increasing their expectations for a potential rate hike since Fed Chair Kevin Warsh's Jackson Hole speech in August, in which he signaled concerns over sticky inflation running above the Fed's target and that its interest-rate policy is a predominant tool to to achieve its dual mandate of price stability and maximum employment.
"The markets can stomach" a rate increase from the Fed as an outcome of its meeting on Wednesday, and maybe one more in 2026, because "inflation is a problem and the Fed is facing credibility challenges politically," said Tom Essaye, founder and president of Sevens Report Research, in a note Tuesday. A policy adjustment that adds up to "a 'one or two and done' rate decision will help to push back on inflation and the narrative the Fed isn't independent," amid concerns that it may be under pressure from the White House to lower rates, Essaye said.
Over the past few months, a "perception in the markets" that the Fed's independence is at stake has contributed to the rise in yields in the bond market, according to his note. The stock market has sold off this month amid a jump in bond yields, with the rate on the 10-year Treasury rate BX:TMUBMUSD10Y climbing to around 5% in Tuesday trading. Bond yields and prices move in opposite directions.
Even if the Fed decides to keep rates steady but signals a potential hike later this year, stocks and bonds could see some pain on Wednesday, said Essaye. That may emerge after an initial "relief rally" triggered by trading algorithms, driven by the notion that fewer rate increases are preferable, he noted, "but I would be surprised if those early gains hold because of inflation and credibility concerns."
Under such a scenario, he anticipates that longer-dated Treasury yields would probably climb, weighing on the stock market, while the "debasement trade" could be reignited. The dollar debasement trade could spark a weakening of the greenback and the outperformance of crypto, commodities like gold (GC00) and hard assets.
By contrast, the 10-year Treasury yield "should fall a few basis points" if the Fed on Wednesday "proves it's serious on inflation," according to Essaye.
While many investors believe the U.S. stock market can digest a rate hike, a signal from the Fed that this would mark the start of a rate-hiking cycle consisting of three or more moves could rattle some nerves.
In that case, "we'd expect stocks to fall (likely more than 1%) and be led lower by cyclicals, value and high-growth tech as yields rise and concern about economic growth grows," Essaye said.
To his thinking, "the 10-year would surge solidly above 5.00%," hurting markets. The U.S. dollar would probably jump against other major currencies "on this surprise outcome," he said.
The U.S. stock market was falling Tuesday as Treasury yields edged higher, with the S&P 500 SPX, Dow Jones Industrial Average DJIA and Nasdaq Composite COMP all deepening their losses so far this month, according to FactSet data, at last check. The yield on the 10-year Treasury note was up about 3 basis points on Tuesday afternoon at around 5.01%, according to FactSet data, at last check.
Still, the S&P 500 remains up in 2026, with a gain of almost 11% based on Tuesday afternoon trading levels. That's after the index finished Monday 2.3% below its record closing high booked Aug. 13, according to Dow Jones Market Data.
Traders in the federal-funds futures market were pricing in on Tuesday a high probability - 92.5% - that the Fed will decide on Wednesday to raise its benchmark rate by a quarter-percentage point to a range of 3.75% to 4%, according to the CME FedWatch Tool, at last check. The Fed will announce its rate decision at 2 p.m. Eastern on Wednesday, with Warsh expected to host a press conference at 2:30 p.m.
Even small-cap stocks, which tend to be more sensitive to higher borrowing costs, seem well-positioned to digest an interest-rate hike on Wednesday, according to Francis Gannon, co-chief investment officer at Royce Investment Partners. In an interview with MarketWatch, he cited their earnings growth, an expanding U.S. economy and the so-called hyperscalers' investment in artificial intelligence as helping small-cap stocks to withstand a potential rate increase.
Check out: Investors worried about rising bond yields are keeping a close eye on this corner of the market
But an aggressive series of rate hikes would risk dampening growth and that could hurt the stock market, including small-cap equities RUT SML, said Gannon.
"The unsung hero of this bull market has been very strong and resilient economic growth. That's being powered by the AI infrastructure boom and it is providing the basis for the earnings growth that's justifying the rally," said Essaye.
-Christine Idzelis
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