The Federal Reserve raised its policy rate by a quarter point to 3.75% to 4% on September 16, its first increase since 2023, marking a hawkish turn. This move was unanimous, with Fed Chair Kevin Warsh emphasizing that inflation remains too high, and projections indicate at least one more rate hike before year-end. Core PCE inflation is near 3.3%, headline inflation is closer to 3.7%, and oil prices are above $100 amidst Middle East tensions, all contributing to the Fed's cautious stance.
Initially, markets reacted negatively to the hike, with the S&P 500 closing lower on the day of the announcement, a rarity for the start of a tightening cycle since 1997. However, sentiment shifted, and the Nasdaq 100 rallied 1.73% to close at 29,446.98 as Brent crude eased back towards $102 and the 10-year Treasury yield dropped to about 4.94%. This bounce suggests that risk appetite is still present, even as investors weigh the immediate costs of higher rates against the potential for inflation control. Resilient labor data, with weekly jobless claims at a six-week low of 196,000, is helping to mitigate recession fears.
The bull case for the market relies on continued softening of oil prices, a strong labor market, and the maintenance of a long-term upward trend. A benign Personal Consumption Expenditures (PCE) print on September 30 could reinforce the idea that the hawkish repricing is largely complete, potentially pushing markets towards new highs. Conversely, the bear case posits that the Fed will follow through on its hawkish signals with another rate hike. High 10-year Treasury yields and mortgage rates around 7.2% could negatively impact technology companies and other rate-sensitive assets.
Investors are grappling with increased confidence in the Fed's commitment to fighting inflation but also uncertainty regarding the extent of future rate hikes, which is expected to cause volatility in stocks and bonds. The unanimous decision to hike rates significantly increases the probability of another move before year-end, leading some investors to recalibrate their portfolios, particularly those who were anticipating an easing cycle. While some analysts believe much of the tightening risk is already priced in, the key question remains whether the Fed views this as sufficient or the beginning of a more extensive tightening period.
Historically, stocks often decline in the three months following an initial rate hike, with a median drop of 2.7%, though they typically rebound over a year. During full tightening cycles, stocks have historically traded higher 86% of the time, even when recessions eventually occurred. For bonds, 10-year US Treasury yields generally rise after the initial hike, leading to price declines. Fed Funds futures currently suggest roughly even odds of another hike at the Fed's next meeting in October, with more hikes priced in for 2027.
