The outcome of today’s Federal Reserve decision should be one of the easiest ones to predict this year.
The CME FedWatch Tool currently puts the probability that the Fed holds rates steady at about 90%, versus just a 10% chance of another quarter-point hike.
That’s a dramatic shift from only a month ago, when markets were pricing in a 64% probability of an October hike.
So, what changed?
It’s certainly not that the inflation problem has evaporated like the glorious days of summer (where did it go?).
September CPI accelerated to 3.7% from 3.4% in August, while core PCE, the Fed’s preferred inflation gauge, is still running around 3%. That’s well above the Fed’s 2% target.
Still, rather than being in a rush to hike, the Fed seems to think it has the luxury of time.
September payrolls increased by just 29,000, providing little evidence that the labor market is overheating. And since September’s 25-basis-point hike, Fed officials have repeatedly indicated they don’t need to raise rates again immediately.
That means the message for investors today is likely to be a pause. But don’t mistake it for a pivot.
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The Fed Isn’t Done Fighting Inflation
There’s still a strong case for additional tightening after the October meeting.
Economic growth remains resilient, the AI investment boom continues to drive capital spending, and inflation has proven to be persistently stubborn.
J.P. Morgan economists recently quantified just how much the Fed’s tone has changed. Their proprietary Hawk-Dove Score for U.S. policymakers recently stood at +33.6, up from just +5.0 one month ago. Since higher scores indicate more hawkish commentary, that’s a significant shift toward inflation fighting and additional tightening, even if it doesn’t happen today.
That said, J.P. Morgan expects a shallow hiking cycle, not an aggressive tightening campaign like 2022. While inflation has remained sticky, analysts at the bank believe that energy and some technology-related input-cost pressures will ease, reducing some of the recent upward pressure on prices.
So, today’s meeting isn’t really about whether or not a quarter-point hike matters right now. It’s about Warsh convincing investors that the Fed remains serious about inflation, without raising fears that a series of economy-crushing hikes is coming.
For small-cap investors, there’s another number I’ll be watching even more closely than the fed funds rate.
Small Caps Need the 10-Year to Behave
The 10-year Treasury yield surged through September and early October, eventually reaching roughly 5.36% before retreating back toward 5%.
That move had a major impact on small caps.
The S&P 600 peaked above 1,830 in August, then rolled over as long-term rates surged, falling to about 1,640 in mid-October.
The pullback in smaller companies – which was much more severe than in large caps – is not surprising. Smaller companies typically have fewer financing options and feel higher borrowing costs more directly. Higher Treasury yields also make shares of small-cap stocks less attractive relative to bonds.
The good news is that the 10-year has stopped going straight up.
As yields have stabilized around 5%, the S&P 600 has also stabilized around the 1,690 level. It is back above its 200- and 25-day moving average lines, and knocking on the door of its 50-day line.
Small-cap investors take note: Today’s bond-market reaction may ultimately matter more than the widely expected Fed decision itself. If Warsh strikes the right balance and the 10-year remains around current levels, or moves lower, the odds of small caps continuing to recover go up.
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