Could the Fed Raise Rates Again in December? Inside Wall Street’s Biggest Question

The Fed is holding interest rates steady, but the debate over what comes next is far from over, with energy prices elevated, inflation still a concern, and markets eyeing a potential December rate cut. Investors are weighing what the Fed's next move could mean for stocks. Joining us now to break it all down is Thomas DeFazio, ETF strategist at Roundhill Investments. Thank you so much for being here, Thomas. We really appreciate it. It's my pleasure, Justine. Thanks for having me. Of course. Yeah, this is such a pivotal moment right now. After this latest meeting, the Fed has decided to hold rates steady. What's your biggest takeaway from today's decision? And also, what does it really tell us about where the central bank thinks the economy stands right at this moment? Yeah, I think my big takeaway is that Chair Warsh wants to keep everyone on their toes. He made it very purposeful that he was not intent to give any type of guidance, though he did say that he and the whole board were looking out the window and trying to be considerate of the real-world impacts. Um, so. So I do think that does leave a little bit of a question mark here for market participants The economy is a little bit stronger, which is a positive overall. Consumption's been good. We've seen GDP revisions higher from the previous few quarters, which is great. But inflation still is a problem when you consider, if you look at the components of PCE, the breadth of those metrics that are above 3%, that's still elevated. And then if you were to do the same thing with CPI, you're still seeing greater than 60% of CPI components above 2%. So there is still inflation out in the system and the ongoing geopolitical situation and higher energy prices is not helping. I do think that while we didn't see any type of action this meeting, I do think this ups the ante for some action come December. So inflation really remains a concern here, particularly with energy prices elevated amid the Iran-U.S. conflict, so much uncertainty there. How much of a challenge does that really create for the Fed as it tries to bring inflation down without actually hurting economic growth? Yeah. And that's really that's really the million dollar question. They're trying to thread a needle, which, as we've seen with monetary policy historically, is very difficult to do. And now we also are in this interesting backdrop where we are trying to help. Let the economy grow and manage various headwinds, inflation being the number one, but also being able to remain confident in the consumption and the consumer to continue to grow at this pace without having inflation go crazy and then having to take another leg higher. So it's a really it's a really interesting dynamic. I think that right now it is one where. We're going to have to tread carefully. It's clear that Chairman Warsh really cares about getting more information and following the trend of the data. And we're about to enter what he and the board think is a very dense period of information. So I think we're going to have a lot more color come December. I think we definitely will. I mean, markets have been pricing in another rate cut in December. After today's decision, how much confidence do you think investors should really have in that outcome? And what do you think could change the Fed's thinking, especially given all these topics we've been talking about, all these moving pieces of the puzzle kind of coming together? Yeah, I think it starts with PCE tomorrow, the Fed's preferred barometer. We're going to see where that ticks up. And I think right now, because today was a hold, I think a lot of market participants are pricing in a much more of a short thing for a hike come December. I think that remains to be seen. We're going to get another jobs report, which will tell us about the strength of the overall market, the employment market. The unemployment rate has been fine. We're at full employment. And right now, I think the Fed really is more about managing inflation than it is about managing economic strength at this point in time. Yeah, I think you're definitely right. And I think that that inflation management is so important and so important in the mind of people who are out there trying to get gas, trying to go to the grocery store, thinking about the actual cost of goods out there. Looking a little bit more at the market, I mean, small cap stocks have been particularly sensitive to interest rates and inflation expectations. So why does the Russell 2000 tend to react so strongly to the Fed's decisions? Yeah, the Russell 2000 is, I would say, patient zero for Fed policy. We think that the S&P 500 and the NASDAQ 100 care more about Anthropic's public filing of its IPO documents than it does Fed policy at this point in time. They're much larger, have the cash to manage this type of environment without much worry about changes in interest rates. Small caps do not have that luxury. And when you've looked at the past 12 months of data, they have taken 100 basis point rises in interest rates and breakeven inflation rates. a lot harder than the headline large cap indices. So if this really ups the ante, while small caps were up marginally on the day today, and they saw some volatility during Chair Powell's press conference today. But overall, I think the small caps are really going to care about what does longer term Fed policy look like. Um, these companies do not have balance sheets and access to capital markets that a lot of their larger cap counterparts have. And that makes them naturally a little bit more sensitive to the incremental changes in policy. Yeah, those incremental changes, again, as you're saying, have such a big bearing on these smaller caps compared to some of these others that we're seeing. If energy prices end up staying high and inflation proves to be a bit stickier than expected, do you think that the Fed would then be forced to keep rates higher for longer and even revisit rate hikes? And also, what would that really do then for these small cap stocks? Yeah. If they have to keep interest rates higher for longer, that does impact small caps. And we think it would do so negatively. Right now, the Russell 2000 has this really interesting and unusual backdrop. And they have seen lower interest rates lately and strengthening economic data. Now, those two don't usually go together, but that is actually the type of cocktail that small caps have needed in order to work in this environment. Coming off of deep oversold conditions has also helped that. But ultimately, if economic growth continues to strengthen, you typically tend to see a coincident rise in interest rates to reflect that growth. So, um... If the Fed has to raise interest rates to help make sure that the economy doesn't run too hot, you end up having the punch bowl taken away from the small cap contingents of the market, just when things were starting to get a little bit easier for these smaller companies. So it really is an unusual and somewhat of a paradoxical situation that small caps are in. I think right now, small caps are really happy with How things happen today. Not much has changed. Interest rates are off the highs and the economy has shown some signs of improvement. The question is, is there a shot clock? And the market right now, I think, is pricing one in come December's meeting. Yeah, I think it definitely looks that way. And we have to keep our eyes on what does happen to those small caps in all of this. Also now looking at bonds, how are bond yields really responding to the Fed's decision? And also, what should investors really be taking away from the relationship between Treasury yields, inflation expectations, and equity market performance when we look at all of those factors coming together? Yeah. So coming out of the meeting and the press conference, we saw the 2/10 curve steepen. The two-year yield particularly fell off of some of Chair Warsh's comments there and the longer end rallied. But I think overall for the market as a whole, we are watching a couple pain points. We've done some work that implies around 5.3% on the 10-year. is a real pain point for the markets. And that's really just a general zone. When you get to that certain level of interest rates, we really start to have this dynamic of, are there other alternatives for investors than just stocks? After coming off of a zero interest rate regime, this is the question investors are starting to ask. Now, the other dynamic that we'll likely have to continue to manage is the rate of change of these interest rates. And that's where perhaps Fed policy can be a little bit more friendly to equities. I think everyone would be happier if we didn't have to hike interest rates. But the pace of those hikes and Chair Warsh's inclination to watch data trends and to manage the pace at which they are hiking. I think is actually a welcome sign for stocks and may help overall financial market digestion. Now, the bond market could keep some of it in check, but that will remain to be seen. Yeah, we definitely need to keep our eye on that. And in speaking about all of these different policies and policy changes, we also have to keep in mind that the midterm elections are approaching. So how much are political uncertainty and really the broader economic backdrop influencing investor sentiment right now? I mean, are you seeing opportunities in any particular parts of the market, keeping in mind this kind of broader political kind of moment that we're facing here with elections coming up? Yeah. So coming into coming into the midterm elections, we have been seeing some defensive posture. Now, that's not necessarily crazy. When you look back historically, you tend to see defensive posture and going into the into the election because there's uncertainty around all these various outcomes and investors manage their portfolios. As a result, health care tends to be a winner. And there's been a really strong outperformer going into this election that. And you've even started to see some nuanced relative performance from staples and utility stocks. Meanwhile, technology is taking it on the chin. Now, that's partly an AI trade sign there. But I think that does show that midterm elections, whether all investors are willing to admit it or not, are playing a factor in their portfolio management. Now, the key going forward is the clearing of that. Um, After elections, midterm elections, the market has a really, really strong run rate and tends to be higher a year after the election results. So what I think now will be really interesting is how and how is the market going to take what is right now their pricing in a Democratic sweep? And then what will happen for the riskier corners of the market? Some of the growthier pockets are under fire lately. Are the midterm elections going to be enough to help shake off? Some of the turbulence they've been experiencing lately. History would suggest that the answer is yes, but I think we do need to take in the broader environment going on, which is we have some geopolitical overhang. We have some policy uncertainty from inflation and what the Fed could do next year. But. If you're a longer-term investor, you have to then just start to answer a question, which is, how can I manage my tactical risk with my longer-term risk-reward profile? And I think most people, if you're considering the short-term, you're more tactically cautious. But in the longer term, especially post-midterm elections, you'll start to get more excited about stocks. Yep. Such an important question to keep in mind and how all of this will move forward. We will wait and see. It remains to be seen, but we really appreciate you being here and breaking this all down for us today. Thomas DeFazio, ETF strategist at Roundhill Investments. Thank you so much for your time. My pleasure, Justine. Thanks for having me.