As the Federal Reserve convenes this week, traders have largely priced in a 25-basis-point rate hike, with odds standing at 87% following hotter-than-expected inflation data. Yet the more disruptive scenario for financial markets may be if the central bank opts to hold rates steady, a move that could reignite doubts about its inflation-fighting resolve and push long-term Treasury yields sharply higher.
Wall Street shifts from debate to expectation
Just a week ago, the probability of a September hike hovered around 70%. But after August's consumer price index (CPI) and producer price index (PPI) reports came in above forecasts, the market swiftly moved to near-certainty. Headline CPI rose 0.4% month-over-month and 3.4% year-over-year, while core CPI climbed 0.3% monthly, beating the 0.2% consensus, with annual core inflation at 2.4%.
Goldman Sachs and JPMorgan have both abandoned their previous calls for a hold, now expecting a quarter-point increase. Goldman economist David Mericle told the Financial Times that policymakers would likely worry about the market reaction if they failed to deliver a hike that recent Fed communication has guided investors to almost fully price in.
Investors have already adjusted to higher short-term rates. A hike would confirm the expected policy path, though it could still pressure rate-sensitive assets. In contrast, doing nothing has become the more disruptive trade.
A pause could lift long-term yields
Typically, leaving rates unchanged would support bonds, but this meeting could produce the opposite effect. The 10-year Treasury yield is hovering near 5%, after touching 4.98% last week, as investors grapple with sticky inflation, expensive oil, heavy government borrowing, and fiscal concerns.
Goldman Sachs trader Rich Privorotsky told MarketWatch that the danger of not hiking is that the Fed may lose control of the back end of the curve if investors conclude policymakers are not serious enough about inflation. That matters for equities, as rising long-term yields increase discount rates, make Treasuries more competitive with stocks, and particularly pressure expensive technology and growth shares.
A pause could therefore appear dovish at the front end while tightening financial conditions further out the curve. That is what makes Wednesday unusual: the seemingly easier policy choice could trigger the harsher market reaction.
Credibility at stake
The debate extends beyond another 25 basis points. Headline inflation remains at 3.4%, core inflation surprised to the upside, and Brent crude remains above $100 as Middle East supply risks keep energy prices elevated. The federal funds target range currently stands at 3.5% to 3.75%.
Chris Zaccarelli, chief investment officer at Northlight Asset Management, said it was difficult to see how policymakers could justify standing still. “There’s no guarantee that the Fed will hike next week, but it’s hard to see how the central bank can justify leaving rates on hold,” he told MarketWatch.
A well-communicated pause could still work if the Fed signals that future tightening remains available. But hesitation without a clear explanation could raise doubts about whether policymakers are prepared to tolerate inflation above target.
As the decision approaches, investors are also watching gold's slide amid rising yields and oil prices, while bitcoin hovers near key resistance ahead of the Fed. The yen's weakness and inflation's persistence add to the complex backdrop.
This article is for informational purposes only and does not constitute financial advice.
