Fed in 'Really Tough Corner' as Investors Await Rate Hike

Investors reeling from one of the worst years on record for financial assets have one last hope for a lifeline: the Federal Reserve.

Odds remain high that Jerome Powell will announce a quarter-point rate increase Wednesday, but it’s what comes next that has Wall Street on edge.

“They’ve been backed into a really tough corner right now with all the noise coming out in the market as to what they should or shouldn’t do, and basically what they’re mandated to do,” said Terri Spath, a portfolio manager at Sierra Mutual Funds, on Bloomberg TV.

Will officials execute a “dovish hike,” signaling a slowdown in the pace of future increases? Will they remove the phrase “further gradual” hikes, indicating a flat-out pause? Will Powell address political pressure from the White House?

The line the Fed will try to walk is razor thin.

Here’s how investors are preparing to respond:

Equities

The Fed may have the toughest time appeasing equity investors. The S&P 500 has plunged almost 10 percent since the Fed’s last meeting and closed Monday at the lowest level of the year -- a bout of weakness rarely seen ahead of interest-rate hike.

A dovish Fed that indicates an end to pre-ordained hikes and a switch to more dependence on economic data would go a long way to allaying concerns that the central bank will tighten the economy into a slowdown, according to Phil Camporeale, managing director of multi-asset solutions for J.P. Morgan Asset Management.

But a too-dovish Fed could raise the specter of an economic slowdown and spook stocks into a bear market, warns Chris Rupkey, chief financial economist at MUFG Union Bank in New York.

“For all we know, investors will be suspicious if the Fed backs off its gradual pace of rate hikes at Wednesday’s meeting because it might indicate policy officials are worried about the economic growth outlook,” Rupkey said.

Bonds

Bond traders will train their attention on the plot of dots that indicate officials’ expectations for future rate levels. Policy-makers projected three increases next year when they last laid out their views in September. There’s been a violent repricing in the months since, sending the yield curve to its first inversion in over a decade.

Here, too, traders want a very tailored message -- dovish, but not too pessimistic. For Societe Generale, that means lowering expectations to two hikes from three.

“If there’s a meaningful lowering in the dots from three to one, that’s a very dramatic move,” said Subadra Rajappa, head of U.S. rates strategy at SocGen. Such a drop would send 10-year Treasury yields tumbling below 2.75 percent, she said. Her expectation is the dots will fall from three to two.

FX

Rampant expectations for a dovish Fed should benefit dollar bulls, according to Citigroup strategists. And even with the dollar near its 2018 highs, bears have little reason to expect any impetus from Wednesday’s decision.

“It’s very hard for this meeting to ‘out-dove’ market expectations. To do this, the Fed basically needs to not hike,” said Calvin Tse, Citi’s North American head of G-10 FX strategy. “The dollar’s bias is to strengthen rather than weaken, given how dovish market expectations already are.”

Hedge funds and other large speculators seem to agree. Bullish dollar bets are close to the highest level since January 2017, according to the latest Commodity Futures Trading Commission data.

Tse expects the Fed to sound more “cautious” and policy-makers to lower next year’s dots from three hikes to two. The greenback could see some of its biggest gains against the euro, he said, as U.S. and European economic data diverge. The dollar has gained over 5 percent against the common currency in 2018.

Emerging Markets

Any signal the Fed is ready to slow its marching of rates higher would be the best outcome for emerging-market stocks that slumped into a bear market in October.

Goldman Sachs counts on a Fed slowdown to support a recovery in developing-nation assets next year, and the mere hint that the Fed could end its hiking led some money managers to re-examine the asset class last month.

James Syme, a London-based money manager at JO Hambro Capital Management, said the Fed could cause emerging-market equities to rally “potentially quite powerfully,” given valuations are already at attractive levels.