Why the Fed Will Disappoint the Stock Market, Even if It Cuts Rates in September

Chair of the U.S. Federal Reserve Jerome Powell. (MANDEL NGAN/AFP via Getty Images)

Stocks might get their September interest-rate cut, but the Federal Reserve could still disappoint the market, as soon as this month.

The stock market needs a September cut to justify its lofty level. The S&P 500 , at just over 6400, is up 10% this year after having hit records this week. Sure, part of the rally emanates from Big Tech’s stellar earnings season —which has given investors confidence that the entire market’s growth story can continue. But underpinning the optimism for tech and other sectors is the expectation that the Fed will lower the federal-funds rate at its Sept. 16-17 meeting.

But even if the Fed delivers a September rate cut—the fed-funds futures market assigns a 85% probability of a quarter-percentage-point rate reduction—Chair Jerome Powell could still offer a hawkish view. In other words, the Fed could remain focused on battling inflation and signal a plan to keep rates relatively elevated. While markets are betting aggressively on a September rate cut, the Fed is far less likely to impose a series of additional cuts after that.

That means investors shouldn’t bet too heavily on stocks right now: Hawkish messaging at September’s meeting could trigger a broad market pullback.

The Fed is likely to strike a hawkish tone soon, “a development that is not priced in with stocks at record highs,” writes Sevens Report’s Tom Essaye.

That’s because the Fed’s preferred gauge of inflation, the Personal Consumption Expenditures Index, rose 2.6% year over year in June, above policymakers‘ 2% goal. Economists expect that PCE data later this month will show that inflation remained at that 2.6% pace in July. Lowering rates too quickly could stoke enough consumer demand and inflation to impede the Fed’s goal. The Fed also has to contend with tariffs, which have recently caused businesses’ costs to rise faster than consumer prices. That could push companies to charge more for their goods and services, driving up consumer prices even more.

“Inflation [is] hiding in plain sight,” writes Wolfe Research’s chief investment strategist, Chris Senyek, who expects “a hawkish surprise next week.”

This week is the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming. There, Powell could indicate that, after a September cut, the Fed will carefully monitor inflation data before deciding on any further rate reductions.

That’s a problem for markets. The fed-funds futures market is currently reflecting just over two cuts by the end of the year. That’s why the two-year Treasury’s yield—a barometer for expectations about the fed-funds rate—is down to 3.73% its peak of 4.06% since April. In other words, the fixed-income market is reflecting rate cuts that aren’t likely to materialize, so the two-year yield could shift higher over the coming months.

If it does, stocks could falter as investors expect higher rates—a major disappointment The stock market has risen as the two-year yield has dropped in the past few months, as Wall Street holds out hope for multiple cuts. But if the two-year note bounces back to that mini-peak of 4.06% hit on May 14, the S&P 500 would likely tumble.

Consider this: When the two-year yield was at that May 14 high, the S&P 500 traded at 21.4 times expected aggregate earnings for the following 12 months. Today, the index trades at 22.5 times, as lower rates would bring about a greater probability that companies’ earnings meet current expectations. But if the Fed sounds hawkish and yields rise, that multiple could drop to around that May level.

That would send the S&P 500 down almost 5% to nearly 6100. A stock market decline could even be slightly worse than, eventually—if rates remain higher for longer, economic growth slows, and analysts reduce their earnings estimates.

Now is not the time to aggressively buy stocks, if investors don’t want to be disappointed with their returns, too.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com