With a fresh rate hike likely this week, US Federal Reserve may disappoint the bulls again

THE stock bulls are once again betting that US Federal Reserve chairman Jerome Powell will offer a reprieve to the US economy, risking another major selloff should he once more cast a cold eye and forge ahead with his inflation fight.

The Fed is widely expected to raise rates by 25 basis points on Wednesday (Feb 1), a step down from a 50-basis point increase in December and from four straight mammoth 75 basis point moves before that. With inflation moderating, any other rate move would come as a shock.

A small hike alone will not be enough to feed the bulls’ insatiable appetite for Fed attention. Equity buyers are hoping for a statement like the one from the Canadian central bank earlier in January, when the bank’s governor explicitly laid out plans to pause rate hikes, adding that “we have turned a corner on inflation”.

“The Fed is likely to acknowledge that its steps are working, that there’s still work to be done, but hopefully we also get, much like the Bank of Canada. a hint that they are getting ready to slow down and perhaps pause,” said Oliver Pursche, senior vice-president at financial advisory Wealthspire.

The broad S&P500 has risen roughly 6 per cent for the year to date, largely because of bets that such a hint was in the offing. 

There were similar gains – and similar hopes – ahead of Fed statements last August and again in November. Each time, Powell went out of his way to push back on the market rumours.

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Like drunken party guests, the bulls keep insisting that the Fed bring back the punchbowl, and stop being coy with refusals. Like a sober host, Powell keeps warning about the dangers of such ebullience in a time of inflation.

Nothing that Powell says about his intentions to keep hiking rates seems to get through to the bulls. Bond markets have priced in a rate cut this year, despite the denials. It’s a staredown – either Powell relents, or the bulls will be forced to bail out of their bets. That could mean not only wiping out the 6 per cent gains for the year to date, but testing the bear-market lows more than 12 per cent below the current S&P 500 level.

One thing for sure is that inflation has reached a peak, at least in the short term. The December 2022 US consumer price index reading was the weakest in more than a year, and the first monthly negative reading since 2020. The prices of used cars, houses and building materials have all rolled over.

Natural gas, a key feedstock for a broad range of chemicals and plastics, has fallen by more than half since its peak late last year as mild weather in the US and Europe has alleviated shortage fears.

Other inflation factors are still at large, warned JJ Kinahan, the chief executive of IG North America, the parent company of options firm tastytrade. 

The Russia-led war in Ukraine is still going on, and that keeps upward pressure on grains and oil. In the US oil futures are creeping up above US$80 a barrel. At this rate, petrol prices will soon eat into discretionary spending once more. Already, the average price in the US is above US$3.50 a gallon.

The Fed is unlikely to be deterred from hawkish inflation rhetoric by the risk of a major selloff in stocks. Clearly, Powell is not afraid to be a spoilsport. If anything, the central banker seems more inclined to teach the stock market a lesson. In December, he warned that market pre-emptions of interest rate moves were complicating efforts to use the tools to control inflation. 

One reason the Fed could pause, however, is the darkening economic picture. Fourth-quarter earnings season is beginning to feel more like fourth-quarter layoff season, with corporations from chemicals giant Dow to toymaker Hasbro all warning of major staff cuts to come.

It’s a familiar refrain, by now: concerns about dwindling demand have forced the company to make across-the-board job cuts. Some of the companies who haven’t laid workers off yet, such as Intel, have posted earnings slowdowns so severe that job cuts seem inevitable.

“The question the Fed’s going to have to wrestle with over the next couple of meetings, is what are these potential layoffs going to mean,” said Kinahan. “We have seen (something) like 500,000 layoffs over the last couple of months. At some point, that’s going to reverberate through the economy...”

“They have a narrower needle to thread in terms of keeping the economy from imploding while at the same time making sure inflation doesn’t get out of hand,” he added.

The Fed’s ferocious rate hikes may already have caused enough bleeding in the economy to bring on a major recession. While economic data has been mixed of late, certain key indicators, such as business investment and regional factory surveys, have turned negative. Powell himself has expressed doubts that the central bank can win the war on inflation without fatally wounding the economy. 

After many dashed hopes, the stock bulls may hear Powell concede that the rate hike cycle is “closer to the end than to the beginning”, as Pursche put it. But the Fed chairman could still have a sobering effect on markets if he says the hikes must stop because of an oncoming recession.