Investors will look to the Fed to soothe the market next week, but that may be a tall order

Federal Reserve Chairman Jerome Powell, wearing a face mask, testifies before the House of Representatives Financial Services Committee during a hearing on oversight of the Treasury Department and Federal Reserve response to the outbreak of the coronavirus disease (COVID-19), on Capitol Hill in Washington, U.S., June 30, 2020.

Tasos Katopodis | Reuters

Markets are looking to the Federal Reserve to be a soothing force when it meets in the week ahead, but stocks could remain choppy if the central bank disappoints and as investors focus on the election and the economic recovery.

The Fed’s two-day meeting is expected to end Wednesday with minor tweaks to its statement and some clarity on how it plans to use forward guidance. The Fed also updates its economic and interest rate outlook, including forecasts for 2023 for the first time.

But Quincy Krosby, chief investment strategist at Prudential Financial, said the stock market could easily be disappointed because the Fed is unlikely to offer more clarity on monetary policy, such as plans for bond buying.

“The market is concerned the Fed is not going to give us explicit readings on their plans for monetary policy,” she said. The Fed’s extraordinary policies have been an important factor behind the stock market’s 50% surge from the March 23 low, and it’s also seen as a major factor limiting the depth of the market’s sell-off.

Peter Boockvar, chief investment officer at Bleakley Advisory Group, said the Fed is not likely to tweak much and it continues to buy $80 billion a month in Treasurys. “I don’t think they’ll do anything to the markets either way,” he said.

Stocks were volatile in the past week, falling hard and rallying again, leaving the S&P 500 with a decline of about 3% for the week. The harder hit Nasdaq was down about 5% for the week. The quadruple expiration of options and futures at the end of the coming week could add to the volatility.

Bank of America strategists said the bond market is watching the Fed for any balance sheet adjustments and the changes to its forward guidance, which includes the Fed’s recent tweak in its inflation policy. The Fed changed its policy of focusing on a target inflation rate to an average rate, meaning it may not tighten policy if inflation overshoots its 2% target.

“We see risk the rates market is underwhelmed by the guidance provided by the Fed, which would support higher back-end rates and a steeper curve,” the Bank of America strategists noted. The benchmark 10-year yield slid in the past week, touching 0.67% Friday, and it could move higher, meaning bonds may sell-off, if the Fed does not clarify policy around its bond buying program.

Krosby said the stock market is hoping for a dovish Fed. “The market needs that now because fiscal policy is going nowhere,” she said.

BTIG strategist Julian Emanuel said the market could focus on the fact that Congress failed to make headway on fiscal stimulus, if the economic data begins to disappoint.

Retail sales for August are expected Wednesday morning, as the Fed meets. They are expected to rise by 1%, and that should be an important look at whether the lack of enhanced unemployment benefits, which expired July 31, impacted consumer spending. Among other things, Republicans and Democrats could not agree how to replace the $600 weekly payment to the unemployed.

“Depending on the polls and the economic data, the probability of stimulus rises and falls,” said Emanuel, head of equity and derivatives strategy.

“Our view is that next week is just going to be lots of back and forth with the potential for a further extension of the range for the downside, if the political narrative gets more inflamed,” said Emanuel. Emanuel expects the market to remain choppy and fall further into the month of October, as investors worry about the uncertainty around the presidential election.

The Fed’s meeting this week is its last before the election, and analysts expect Fed Chairman Jerome Powell to sound reassuring that the Fed will do whatever it takes to support the economy. Powell holds a briefing after the meeting Wednesday, and he is expected to also be asked about the potential for higher inflation. The Fed has said it is more concerned about disinflation, but recent inflation data has been hotter than expected, though still well below 2%.

“There is a tug of war between those who say buy chips now because inflation is moving higher, versus those why are saying deflationary forces are still weaving their way into the economy,” said Krosby.

Marc Chandler, chief market strategist at Bannockburn Global Forex, said he expects the Fed to sound reassuring but it’s not likely to discuss a target for bond purchases or the yield curve controls some investors were hoping for. Yield curve control would mean the Fed would try to manage interest rates by targeting its purchases of specific Treasurys. For instance, it may focus on trying to keep longer duration yields lower, and buy the 10-year.

Chandler also noted the Fed’s $7 trillion balance sheet has recently declined by about $100 billion from its peak, and its bond purchases are falling behind the European Central Bank.

“My sense is the Fed is going to keep saying it’s not worried about inflation. Its bigger worry is downside risks. They’ll repeat their call for fiscal stimulus which after this week seems less likely,” he said.

Chandler said the stock market could remain choppy in the coming week, but he does not expect a sharp selloff. The dollar could decline, if the Fed sounds dovish, and that is a positive for stocks.

“I don’t think a 10% pullback [in Nasdaq] has caused enough pain to have people capitulate. This is just an ordinary correction, and we’re going to make new highs,” he said.