For the past couple of weeks, markets have become increasingly convinced that the Federal Reserve won’t raise interest rates at its September meeting.
First came July’s surprisingly weak nonfarm payrolls report. Rather than adding 80,000 new jobs as expected, the economy shed 23,000 jobs. Then came softish inflation. The Consumer Price Index (CPI) rose just 0.1% month-over-month (MoM), while producer prices were unchanged.
That caused expectations to shift dramatically. Just over a week ago, markets were about evenly split between the Fed raising rates a quarter-point in September or leaving them unchanged.
But now, hike odds have dropped to around 30%, and investors have reacted accordingly. The S&P 500 recently clocked a new all-time high while the CBOE Volatility Index (VIX) has fallen to its lowest level this year.
Clearly, investors are betting that the Fed will blink. But I think they need to be careful.
The Fed’s meeting is still around a month away. And there’s a lot of data that markets will need to digest…
The Fed didn’t unanimously agree to leave rates unchanged at its last meeting. Three officials dissented in favor of an immediate 0.25% hike.
That tells you a group inside the Fed – a minority – is worried enough about inflation to want rates higher. And we can’t rule out Fed Chair Kevin Warsh joining them.
In fact, I think he’ll plan to raise rates if the economic data justifies it.
He also wants to send the market a message. He doesn’t want investors assuming the Fed will always hand them a clear roadmap for rates – or that policy will keep riding to the rescue.
Between now and the next meeting, there’s another full cycle of monthly economic releases to come. These include the CPI, the Producer Price Index, and Personal Consumption Expenditures inflation data.
And on the jobs front, there are job openings and payrolls to come along with the latest unemployment print. Then, there’s manufacturing, services, retail sales, consumer sentiment, and a broad array of other economic data.
Any surprises could dramatically shift rate expectations higher again. And if folks aren’t careful, that could catch them off-guard.
One theme I often write about is that markets don’t simply move according to whether news is good or bad. What really matters is how that news compares to what investors are expecting.
Right now, investors are factoring in a relatively low probability that the Fed will hike in September. That’s what makes the current setup so intriguing.
If incoming data continues to soften, then today’s expectations might prove correct. The Fed can remain on hold, and markets can simply carry on.
But what happens if the numbers go the other way – like new jobs rebound strongly or oil prices start rising again, putting renewed pressure on inflation?
A sudden repricing of interest rate expectations could push Treasury yields higher. Don’t forget, the U.S. 10-year has recently been pushing 4.7%. Another leg higher could put pressure on fully priced growth stocks and take some of that complacency out of the market.
Stocks are at record highs, and the VIX at its yearly lows. Investors believe the Fed will telegraph its next move.
That’s why markets are vulnerable, especially with a relatively new chair taking the Fed in a new direction.
To be clear, I’m not guaranteeing the Fed will hike rates in September. There are too many factors to make that call right now. But I wouldn’t write it off.
For traders, that’s where real opportunities lie…
Because the bigger opportunity (and risk) isn’t necessarily the Fed raising rates in itself.
It’s what happens when a market that has become convinced the Fed will blink suddenly realizes that it might not…
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
