Will the Fed Save or Further Sink the S&P 500 and Nasdaq 100 this Week?

US STOCKS OUTLOOK:

• The S&P 500 and Nasdaq 100 have sold off in recent weeks on expectations that the FOMC’s tightening cycle could spark an economic downturn
• Traders will have a chance to gauge where policymakers stand on future rate hikes this week, when the FOMC concludes its May policy meeting
• Stocks could stabilize and begin to recover if Powell doesn’t deliver any new hawkish bombshells

Most read: Fed Policy Remains the Biggest Risk for Equity Markets in the Second Quarter

U.S. stocks have plummeted in recent weeks on fears that the Federal Reserve’s aggressive measures to withdraw stimulus to squash inflation will trigger a hard landing of the economy, but with Wall Street in meltdown mode, traders are wondering whether the institution will stay the course or pivot to a less aggressive stance. With CPI readings at four-decade highs, the bank can’t afford to turn dovish, but it can help temper runaway hawkish expectations.

In late March, after numerous Fed officials signaled their willingness to front-load hikes, and inflation accelerated its advance, bets of multiple non-standard 50 basis point interest rate increases were cemented, with July fed funds futures coming to imply 151 bps of tightening from 120 bps (see chart below). Shortly thereafter, the nascent equity rally that occurred for much of that month came to a screeching halt, paving the way for a major sell-off that sent the S&P 500 and Nasdaq 100 plunging 8.8% and 13.4%, respectively, in April. For the S&P 500, it was the third worst start to a year in history.

S&P 500 Futures and Fed Futures Chart prepared using TradingView

Now, some traders believe that policymakers could go even further and raise borrowing costs in 75 basis point increments during the summer to restore price stability. Those expectations have not fully taken hold, but they are still fueling investor anxiety, volatility, and risk aversion. That said, there will be an opportunity to gauge appetite for supersize moves on Wednesday, when the FOMC concludes its May meeting, an event at which the bank is expected to deliver a 50 bp adjustment and announce a plan to begin shrinking its balance sheet. These actions have been widely telegraphed and are fully discounted, so the focus will be on Powell’s press conference and guidance on the pace of the normalization cycle.

S&P 500 INDEX RETURNS FOR SEVERAL PERIODS

Source: Bloomberg

With gross domestic product contracting in the first quarter, the recession narrative gaining momentum and markets in turmoil, I am inclined to believe that Powell will throw a bone to the market and subtly signal that the bank is not currently entertaining raising rates by 75 basis points. This message may help stabilize sentiment and reduce fears that the Fed’s violent actions will lead to an economic downturn.

The alternative is frightening. If Powell comes across as hawkish, stocks could extend losses, a situation that will further undermine confidence and ultimately weigh on consumption through the “wealth effect”. To see this, let’s assume the recent rout continues. Under this scenario, millions of Americans, who have a portion of their wealth tied to stocks, could see the value of their investments plunge, leading them to cut back on spending. If the U.S. consumer falters, a recession may be inevitable. The Federal Reserve knows this, so policymakers may try to improve the mood by offering less aggressive guidance in order to stem the bleeding on Wall Street. The S&P 500 and Nasdaq 100 could rebound should this assumptionplay out.

EDUCATION TOOLS FOR TRADERS

• Are you just getting started? Download the beginners’ guide for FX traders
• Would you like to know more about your trading personality? Take the DailyFX quiz and find out
• IG’s client positioning data provides valuable information on market sentiment. Get your free guide on how to use this powerful trading indicator here.

—Written by Diego Colman, Market Strategist & Contributor