The financial markets are on edge less than 24 hours before a Federal Reserve rate decision, considered one of the most uncertain in years. The probability of the Fed holding rates steady has shifted to 70% from 60% on Monday, while the chance of a hike stands at 30%, which is still unusually high for the eve of an announcement. This uncertainty is a consequence of the Fed's decision to abolish forward guidance, making every meeting “live” for potential policy changes. Fed Chair Kevin Warsh described June's FOMC debate as a "good family fight," and a similar robust exchange of views is expected.
Despite a deep slump in Asian markets earlier in the day and falling oil prices, European and U.S. stock markets showed resilience. The Dow Jones Industrial Average is less than 1% from its record high, and the S&P 500 is 2% away from its peak. This resilience is attributed to a "rotation" of investment, with financials and healthcare sectors hitting record highs on Tuesday, and industrials, consumer staples, utilities, and materials also performing strongly. The Russell 2000 small-cap index is up 19% year-to-date and is only 3% off its record high.
However, the U.S. semiconductor index is in a bear market, down 25% from its June 22 high. This downturn is largely due to concerns over the sustainability of growth in AI-related spending and the increasing cost of insuring against default for major tech companies like Meta, Oracle, Nvidia, and Amazon, which is reaching record highs. While these companies are unlikely to default given their cash generation, the soaring credit default swap costs signal that AI capital expenditure might be nearing bubble territory. Earnings expectations are heavily skewed towards tech, and any disappointment could negatively impact the broader market. Key tech earnings from Meta Platforms, Microsoft, and Amazon are also anticipated this week, which will offer insights into their AI investments.
Oil prices have played a significant role in market sentiment, with Brent crude falling 4.4% to settle at $82.08. Lower oil prices helped ease Treasury yields, with the 10-year Treasury yield dropping from 4.65% to 4.60%. This decline in oil prices also led traders to scale back expectations for a Fed rate hike, with the probability falling to 31.5% from over 36% the previous day. While higher rates could curb inflation, they would also slow the economy. Stronger-than-expected earnings from companies like Sherwin-Williams (up 8.3%) and Coca-Cola (up 5%) have also contributed to the market's overall uplift.
