Market Extra

Why Fed’s response to this key question could spark 5% stock-market pullback or ‘solid rally’

All eyes on the ‘dot plot’ as investor attention shifts to ‘how long’ rates stay elevated

Fed Chair Jerome Powell

Saul Loeb/Agence France-Presse/Getty Images

Stock and bond investors face a crucial twist Wednesday when the Federal Reserve delivers its interest-rate decision.

“The answer to the question ‘How long will rates stay high?’ will now determine if a Fed comment or decision is either hawkish (bad for stocks/bonds) or dovish (good for stocks/bonds),” said Tom Essaye, founder of Sevens Report Research, in a Tuesday note.

That’s a shift from the setup that’s prevailed around Fed meetings since policy makers began a series of rate hikes in March of last year that took the fed-funds rate from near zero to its current level of 5% to 5.25%. Now, the Fed is seen as likely finished — or nearly finished — with rate increases.

While the central bank is almost fully expected to leave rates unchanged Wednesday, market participants will be paying close attention to the so-called dot plot for clues to the timing and scope of future rate cuts. The dot plot is the graph representing individual policy makers’ expectations for future interest rates.

“The market doesn’t expect a Fed hike but the dot-plot, which currently suggests there will be one more this year before a steady fall, thereafter, could see cuts pushed further out, while the tone of the statement is certain to be hawkish, as the FOMC (Federal Open Market Committee) reinforces the ‘higher for longer’ message,” said Kit Juckes, global macro strategist at Société Générale, in a Tuesday note.

Related: When will the Fed decide to cut rates? Here are 5 Wall Street predictions on the path of rates through 2024.

Here’s the FOMC’s June dot plot:

Federal Reserve Summary of Economic Projections, June 14, 2023

Expectations the Fed was nearing the end of its rate-hike cycle have been a pillar of the 2023 stock-market rally since spring, Essaye wrote. Any sign in the Fed policy statement, due at 2 p.m. Eastern on Wednesday, that the accompanying projections or remarks by Fed Chair Jerome Powell upends those assumptions could lead to weakness.

See: 4 things to watch for at this week’s Fed monetary-policy meeting

Essaye warned that if the market is forced to digest “that the Fed is going to keep rates higher for longer, then this market is easily vulnerable to a 5% pullback, if not more,” perhaps in the 10% range.

Check out: Powell could still hammer U.S. stocks on Wednesday even if the Fed doesn’t hike interest rates

If the Fed, on the other hand, leaves rates unchanged, doesn’t change the language around its outlook and the median “dot” for 2024 remains at 4.625%, the market wouldn’t be likely to show much reaction, Essaye said.

A Fed hike on Wednesday would deliver a “real shock” to the market. A bump up in the 2024 dot to 4.875% would also serve to unsettle stocks, Essaye said, with the result likely to be a “steep decline” and a spike higher in the policy-sensitive 2-year Treasury yield BX:TMUBMUSD02Y.

Read: How Fed’s higher-for-longer theme may play out in Treasurys and the dollar on Wednesday

What would it take to spark gains? The June projections had a median 2023 dot of 5.625%, indicating policy makers expected to deliver one additional rate hike before the end of the year. If the dot on Wednesday falls back to 5.375%, it would signal that policy makers think they’re done with hikes, and the result would likely be a “solid rally,” Essaye wrote.

Stocks were under pressure Tuesday as the Fed began its two-day policy meeting, with the Dow Jones Industrial Average DJIA down around 170 points, or 0.5%, while the S&P 500 SPX lost 0.4% and the Nasdaq Composite COMP gave up 0.3%.