A peculiar narrative is gaining traction in financial markets, challenging the conventional wisdom that rising interest rates spell doom for equities. According to the CME FedWatch Tool, there is currently a 90% probability priced in for a rate hike this Wednesday, which would lift the federal funds rate ceiling from 3.75% to 4%. This hawkish shift has been building for a month, fueled by persistent hot inflation data, rising oil prices, and the aggressively anti-inflation rhetoric delivered by Fed Chair Kevin Warsh in August at Jackson Hole. Futures markets also indicate investors have significantly boosted bets on additional quarter-point moves in October and December.

Traditional logic would suggest this is bearish for stocks; higher borrowing costs squeeze corporate finances and diminish the present value of future earnings. However, the market's focus has pivoted dramatically from short-term policy rates to the long end of the Treasury yield curve. The real threat to this equity rally is no longer the Fed's immediate actions, but the upward pressure on long-term yields driven by a deteriorating inflation outlook. Scott Ladner, CIO at Horizon Investments, notes that the real benefit for stocks would come from the signaling effect and the net impact on the long end of the curve. His hope is that the Fed can suppress price pressures with a hike or two without letting long-term yields spiral out of control. This came into sharp focus on Monday when the 10-year Treasury yield touched 5% for the first time since 2023, sending major US indices lower, whereas last Friday saw stocks rally partially on the increased likelihood of a hike.

Hawkish Hike vs. Dovish Hike

The market's reaction to Wednesday's decision will largely hinge on Chair Warsh's press conference. If he maintains the firm stance from Jackson Hole, reiterating the Fed's commitment to crushing inflation and rebuilding policy credibility, investors may front-run further tightening. Rate strategist Mark Cabana at BofA Securities suggests that in this scenario, the 2-year yield could climb 5 to 10 basis points while the 30-year yield might fall by a similar margin. Conversely, if Warsh strikes a more dovish tone—for instance, suggesting this isn't the start of a lengthy cycle—investors could become confused, driving long-term yields higher again. Cabana expects the 2-year yield to drop 5 basis points and the 30-year yield to rise 5 basis points in that case. Cabana frames the choice for the Fed as straightforward: hike now, or risk a chaotic surge in bond yields. Failure to act despite market pricing could trigger a violent and disorderly move in the long end of Treasuries. This paradox explains why a hike might not be the worst news for equities; if it strengthens the Fed's inflation-fighting credibility and compresses long-term yields, stocks stand to benefit.

Betting on Gains While Bracing for a 10% Dip

Historically, the start of a tightening cycle has been unfavorable for stocks. Analyst Michael Graham at Canaccord Genuity, who studied six tightening cycles over the past 30 years, found that the S&P 500 typically falls an average of 3.4% in the month following the first hike. The index usually remains weak for two to three months before longer-term performance improves. If the Fed can use this hike to regain trust, it might alleviate pressure in the bond market, which in turn would lighten the load on equities. Strategist Mislav Matejka at JPMorgan contends that the bulk of the bond yield normalization may already be complete, potentially opening the door for a sustained stock rally. He asserts that the repricing mostly reflects the rebuilding of term premium rather than a signal of spiraling inflation, meaning marginal upward pressure from that channel will weaken.

However, Macro Risk Advisors LLC (MRA) offers a much more cautious outlook. CEO and founder Dean Curnutt warns that starting a new hiking cycle could dent earnings expectations by compressing corporate margins, potentially triggering a pullback in the S&P 500. With September historically being the weakest month for stocks and the index already down nearly 1% this month, the backdrop is tense. Curnutt believes a hike could be just the beginning of greater volatility, forecasting an 8% to 10% correction in the S&P 500 with a possible secondary slump in December. In his client note, he reasoned that a hike will squeeze margins for companies that cannot pass on costs, creating a shock to an unprepared market. Drawing parallels to 2018—where the S&P 500 peaked in September, fell 10% in October and November, and then entered a near-20% drawdown without a Santa Claus rally—Curnutt argues that a defensive posture is the right strategy. He anticipates a similar K-shaped, low-turnover economy and a market that weakens again in December due to repeated Fed hikes.