Wall Street next week: the size and speed of interest rate changes in focus

The Federal Reserve is in the spotlight next week as uncertainty surrounds the topic of how much the Federal Reserve will cut interest rates at its monetary policy meeting and at what pace it will reduce borrowing costs in the months ahead.

 

The S&P 500 Index (.SPX), a new tab, is just one percent below its July record high, despite weeks of market swings driven by worries about the economy and changes in bets on the size of the rate cut at the Federal Reserve's Sept. 17-18 meeting.

 

After fluctuating sharply during the week, fed funds futures on Friday showed traders assessing a nearly equal chance of a 25 basis point rate cut and a 50 basis point cut, according to CME Fedwatch data. The changing rates reflect one of the key questions facing markets today: whether the Fed will apply aggressive cuts to prevent the labor market from weakening or take a slower wait-and-see approach.

 

"The market wants to see the Fed demonstrate a level of confidence that growth is slowing but not falling off a cliff," said Anthony Saglimbene, chief market strategist at Ameriprise Financial. "They want to see that there is still room to gradually normalize monetary policy."

 

Investors will focus on the Fed's fresh economic forecasts and interest rate outlook. Given the LSEG data late Friday, markets are pricing in a one hundred fifteen basis point rate cut by the end of 2024. In comparison, the Fed's June forecast called for a single 25 basis point cut within a year.

 

Walter Todd, chief investment officer at Greenwood Capital, said the central bank should opt for a fifty basis point cut on Wednesday. He pointed to the gap between the 2-year Treasury bond yield, which was around 3.6 percent, and the federal funds rate in the 5.25 percent to 5.5 percent range.

 

That gap is "a signal that the Fed is really tight relative to where the market is," Todd said. "They're starting this cycle of cuts late and they have some catching up to do."

 

Aggressive cut rates have helped boost Treasuries, with the 10-year bond yield down eighty basis points since early July to about 3.65 percent, close to its lowest level since June 2023.

 

But if the Fed continues to forecast much less easing than the market expects this year, bonds will have to reprice, pushing yields higher, said Mike Mullaney, director of global market research at Boston Partners.

 

Rising yields could put pressure on stock valuations, said Mullaney, which are already high relative to historical levels. The S&P 500 Index (.SPX), a new tab, last traded at a forward price-to-earnings ratio of 21 times expected 12-month earnings, compared with its long-term average of 15.7, according to LSEG Datastream data.

 

"I find it unlikely that you're going to see a widening of the P/E ratio between now and year-end in an environment of rising (yields)," Mullaney said.

 

With the S&P 500 up about eighteen percent so far this year, it may take little to disappoint investors at the upcoming Fed meeting.

 

Attention has shifted to the employment market as inflation has softened and job growth has been less robust than expected in the last two monthly reports.

 

The unemployment rate jumped to 4.2 percent in August, a month after the Fed assumed it wouldn't reach that level until 2025, said Oscar Munoz, chief U.S. macro strategist at TD Securities. That indicates the central bank may need to show a willingness to act aggressively to cut rates to "neutral" levels, he added.

 

"If the outlook disappoints, i.e. they become more conservative and don't loosen rates on such a large scale, ... I think the market may not take that positively," Munoz said.