Wall Street is Bracing for a Big Test of the Fed's Dovish Stance

Wall Street is on the edge, anticipating what is poised to be the most pivotal Federal Reserve decision of the year. Traders are eagerly awaiting signals that could shed light on whether the market's enthusiastic embrace of dovish sentiments has been pushed to an extreme.

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The financial landscape, including stocks, bonds, and the dollar, has witnessed mild fluctuations amid speculations that the Federal Reserve will maintain current interest rates on Wednesday. This move is expected to quell expectations of rate cuts exceeding 100 basis points over the next 12 months. The way in which the Federal Reserve articulates its outlook for policy concluding in the coming year and 2025 through its "dot plot" could introduce an element of uncertainty into the market, which has surged ahead of the central bank's projections.

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The Federal Open Market Committee is anticipated to retain rates within the range of 5.25% to 5.5%, marking a 22-year high. The official decision is slated for 2 p.m. in Washington, with Chair Jerome Powell scheduled to address the public 30 minutes later. According to economists surveyed by Bloomberg, the median Fed projection is expected to reveal two rate cuts in the coming year and an additional five in 2025.

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Leading up to the decision, data revealed a deceleration in producer-price gains, attributed to a decline in energy costs. Consumer prices on Tuesday emphasized a decline in the annual rate of inflation, despite a pickup in monthly gains. Collectively, these data points reinforce the idea that inflation is moving back toward the Fed's target.

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The S&P 500 exhibited wavering movements, hovering near its peak since January 2022. Meanwhile, Treasury two-year yields dipped below 4.7%, and the U.S. dollar experienced minimal fluctuations.

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Mark Haefele, Chief Investment Officer at UBS Global Wealth Management, commented on the situation, stating, "While we expect rates to come down in 2024, supporting both equity and bond markets, the speed of recent gains is likely to moderate." Haefele further emphasized that with economic growth expected to decelerate, quality stocks are likely to outperform.

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Any indication from the Federal Reserve that suggests a reluctance to engage in interest-rate cuts could potentially disrupt the relentless stock rally observed since late October. Goldman Sachs Group Inc.'s derivatives and flow specialist, Cullen Morgan, expressed caution, noting that their models are projecting S&P 500 sales under various scenarios in the upcoming week. This comes on the heels of a warning from Morgan's colleagues last week, highlighting the perilously high optimism surrounding stocks and the apparent absence of bearish sentiments.

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Contrary to prevailing sentiments of economic slowdown, Bloomberg Intelligence suggests that the outlook for U.S. stocks heading into 2024 may be more favorable than commonly assumed. Historical data compiled by Bloomberg Intelligence indicates that the S&P 500 Index has historically delivered robust returns in the year following instances where BI's Economic Regime Model first fell below .03, or the Conference Board's index of leading economic indicators declined more than 7.6% from the preceding year—both of which occurred in October.

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In other markets, traders have escalated their bets on interest-rate cuts by the Bank of England in the coming year. Soft GDP data reinforced the belief that policymakers won't be able to sustain tight monetary policies for an extended period. For the first time in the current cycle, markets are fully pricing in 100 basis points of monetary easing in 2024, potentially lowering borrowing costs to 4.25%.