This week, the stock market could do something unusual: rally on a rate hike.
Wall Street is expecting that the Federal Reserve will raise rates this week after Chairman Kevin Warsh's tough speech against inflation at Jackson Hole last month was followed by a series of hot inflation reports, a spike in oil prices and a surge in expectations for a quarter-point increase.
The market is now pricing in a 90% likelihood that the federal funds rate — which serves as a baseline for other borrowing costs such as mortgages — will rise 3.75% to 4.00% following Wednesday's decision, according to the CME FedWatch Tool.
The probability of two more increases coming, in October and December, have also spiked, fed funds futures pricing shows.
What's unusual, however, is the possibility that the stock market could actually rise in that scenario, which the major averages treated as positive on Friday.
Typically, stocks fall on the prospect of higher rates because they raise borrowing costs and lower the value of future earnings. But the prospect of worsening inflation, and the upward pressure that is adding to longer-dated Treasury yields, has traders shifting their priorities to the bond market first.
"It's the signaling impact and the net impact on the long end of the curve that would end up being the positive thing for equity markets," said Scott Ladner, chief investment officer at Horizon. "That's the unusual setup today."
Investors are hoping a rate hike or two from the Fed will tame pricing pressures and keep long-term bond yields anchored.
On Monday, the 10-year Treasury yield hit 5% for the first time since 2023, a development that also hurt equities. The major averages were down across the board at that same time.
Dovish or hawkish hike?
Part of the market reaction may come down to which Warsh shows up at the press conference: the July Fed chief who was vague about the central bank's commitment to tackling inflation, or the Jackson Hole leader who was clear the Fed will do whatever it could do bring inflation down.
If the Fed chair continues to sound tough against inflation, and restores credibility, as he did in August at the Wyoming gathering, the market may immediately pull forward rate expectations.
Bank of America Securities' rates strategist Mark Cabana said he expects 2-year Treasury yields would rise 5 to 10 basis points, while the 30-year rates fall just as much.
But a dovish press conference in which Warsh implies the hike was unpopular, or that only a few hikes will follow, may confuse investors and send longer-dated bond yields higher. Cabana said he expects 2-year yields to fall by 5 basis points, and 30-year rates to rise by 5 basis points in this scenario.
"Fed faces simple choice at Sept FOMC: hike or risk large bond spike," Cabana wrote. "If the Fed does not hike with current pricing, it risks a sharp and disorderly [U.S. Treasury] long end move."
Stock reaction
Typically, the start of a new hiking cycle is a bad sign for stocks. A look at the S&P 500 following the initial rate hikes of six tightening cycles over the last 30-plus years showed that the broader index drops immediately in the month afterward, losing an average 3.4%, according to Canaccord Genuity analyst Michael Graham.
Over the following two to three months, the S&P 500 continues to perform poorly, though the results over the longer term start to improve, the analyst said.
However, if the Fed is able to restore confidence in its commitment to tackling inflation, it could relieve some of the pressure in the bond market, which could then also relieve stocks.
JPMorgan's Mislav Matejka said he expects that much of the normalization of bond yields is already behind investors, which could clear the way for further upside for equities through the end of the year.
"Much of the repricing has reflected the rebuilding of a previously compressed term premium, not a signal that inflation is about to spiral," Matejka wrote. "The marginal upside pressure from this channel should therefore diminish."