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Fed Preview: US Dollar and S&P 500 Could Take Diverging Paths After FOMC De.

Fed Preview: US Dollar and S&P 500 Could Take Diverging Paths After FOMC Demotion
Fed Preview: US Dollar and S&P 500 Could Take Diverging Paths After FOMC Demotion

Market expectations for a rate hike by the Federal Reserve shifted dramatically after two bank failures sparked an avalanche of panic in stock markets and fed funds futures. The CME Group FedWatch tool showed that market participants saw a nearly 70% chance of a rate hike in March, but now only see the central bank raising rates by a 25-basis point at its two-day meeting later this month.

The S&P500 is still up 18.2% year-to-date, but it has fallen 2.7% for the past week. Its forward 12-month earnings growth is negative and analysts are downgrading their long-term earnings estimates.

Traders should be aware that inflation hasn’t yet cooled down to the Fed’s target level. Nevertheless, the Fed is still expected to raise rates in May.

A 25-bps rate increase would lift the benchmark borrowing cost to a range of 4.75-5 percent, boosting risk assets like stocks and gold. But the move could also lead to a pause in the Federal Reserve’s $85 billion-a-month bond buying program.

Bulls Should Beware Of A Slowing In Financial Conditions
The Fed will have to weigh its desire to fight inflation against a potential tightening of financial conditions. Wage growth has been rising above the Fed’s target pace, but that hasn’t translated into price increases. Similarly, the housing market is also tightening, which is contributing to the strong increase in the Consumer Price Index.

Investors should pay close attention to Fed Chair Jerome Powell’s remarks during the monetary policy statement and press conference on Wednesday. If the Fed emphasizes its ongoing fight against inflation, it’s possible that it will be a bit more hawkish than what markets currently expect.

Bears Should Beware Of A Slowing In Inflation
If the Fed signals that its rate hike cycle is nearing an endpoint, then a ‘downside’ scenario for risk assets will play out. The S&P 500 will fall. Alternatively, the Fed will signal that it wants to start a’slowing’ of its rate hike cycle.

The S&P 500 could drop if the Fed starts a’slowing’ of the rate hike cycle, especially if the central bank starts to discount a ‘pause’ or ‘pivot’ in 2023. If that happens, investors will be more focused on the Fed’s expected destination (peak interest rates), rather than the journey. This will likely bolster safe-haven flows and weaken the US Dollar. But it might also be a sign that the economy is weaker than it seems.