The Federal Reserve garners attention in the upcoming week as uncertainty mounts regarding the extent to which the U.S. central bank will reduce interest rates at its monetary policy meeting and the pace of these reductions in the ensuing months.

 

The S&P 500 index (.SPX) is merely one percent below its record high from July, despite recent market volatility triggered by economic concerns and fluctuating predictions on the rate cut size in the Fed's September 17-18 meeting.

 

Fed funds futures experienced significant fluctuations throughout the week. On Friday, traders priced nearly equal chances of a 25 basis point cut and a 50 basis point cut, according to CME Fedwatch. These changing bets underscore a critical issue for today's markets: Will the Fed respond to labor market weakening with prompt cuts, or will it adopt a more cautious approach?

 

"The market wants the Fed to project confidence—that growth is decelerating but not plummeting," stated Anthony Saglimbene, chief market strategist at Ameriprise Financial. "They want assurance ... that there's still the scope to gradually normalize monetary policy."

 

Investors will scrutinize the Fed's new economic projections and interest rate outlook. Markets are predicting one hundred fifteen basis points of cuts by the end of 2024, as per LSEG data from late Friday. In contrast, the Fed's June forecast anticipated just one 25-basis point cut for the year.

 

Walter Todd, chief investment officer at Greenwood Capital, advocates for a fifty basis point cut on Wednesday. He noted the disparity between the 2-year Treasury yield, around 3.6 percent recently, and the Fed funds rate of 5.25%-5.5%.

 

That discrepancy indicates that "the Fed's stance is tight relative to the market," Todd remarked. "They are behind in initiating this cutting cycle and need to catch up."

 

Speculative aggressive rate cuts have fueled a rally in Treasuries, with the 10-year yield dropping approximately eighty basis points since early July to around 3.65 percent, nearing its lowest since June 2023.

 

However, should the Fed continue to forecast significantly less easing than the market anticipates for this year, bonds would need to reprice, leading to higher yields, remarked Mike Mullaney, director of global markets research at Boston Partners.

 

Higher yields might pressure stock valuations, Mullaney noted, which are already elevated relative to historical standards. The S&P 500 (.SPX) was recently trading at a forward price-to-earnings ratio of twenty-one times expected 12-month earnings, against a long-term average of 15.7, based on LSEG Datastream.

 

"It's unrealistic to expect P/E multiple expansion in a rising yield environment through year-end," Mullaney said.

 

With the S&P 500 up about eighteen percent this year, it might not take much for next week's Fed meeting to disappoint investors.

 

Attention has shifted to the employment market as inflation has eased, with recent monthly reports showing less robust job growth than anticipated.

 

The unemployment rate rose to 4.2 percent in August, one month after the Fed projected it would reach that level only in 2025, mentioned Oscar Munoz, chief US macro strategist at TD Securities. This suggests the central bank might need to take assertive action to lower rates to their "neutral" level, he added.

 

"If the forecast disappoints—indicating a more conservative stance and less easing than expected ... the market might not react positively," Munoz said.