Fed Rate-Hike Bets Just Fell. Here's Why Stocks Are Rallying Today

KEY POINTS

• Markets sharply reduced their expectations for a September Fed rate hike after comments from Fed Governor Christopher Waller.

• The probability of a September rate increase fell to roughly 50% from 63.2%.

• The 10-year Treasury yield fell to about 4.76%, easing pressure on stock valuations.

• Investors are now turning their attention to Friday's August employment report and next week's inflation data.

Wall Street got some relief Thursday.

After a rough stretch for bonds and growing concern that the Federal Reserve could raise interest rates again, investors suddenly received a reason to take their foot off the brakes.

Federal Reserve Governor Christopher Waller said he would be inclined to hold interest rates steady at the Fed's September meeting if incoming inflation data continues to show improvement.

Markets reacted immediately.

The probability of a September rate hike fell from 63.2% to roughly 50%, according to CME FedWatch data. At the same time, Treasury yields moved lower and major U.S. stock indexes rallied.

For investors, the message was simple:

The Fed may not be as hawkish as markets feared earlier this week.

Why Waller's Comments Matter

The Federal Reserve has been caught in an uncomfortable position.

Inflation remains well above the central bank's 2% target, but economic growth and the labor market have also shown signs of moderation.

That has created a difficult policy question.

Should the Fed raise rates again to make sure inflation doesn't become entrenched?

Or should policymakers wait and see whether inflation continues to cool?

Waller's comments Thursday leaned toward the second option.

In remarks delivered at a Reuters NEXT event, Waller said recent data showed signs of disinflation. If that improvement continues in the next round of inflation data, he said he would support keeping the federal funds rate at its current level.

But there is an important caveat.

If August inflation comes in hotter than expected, Waller said he could support a rate hike at the Fed's September 15-16 meeting.

So this isn't a guarantee that rates won't rise.

It's a change in the market's perception of the odds.

Treasury Yields Give Stocks a Boost

That shift in expectations quickly showed up in the bond market.

The benchmark 10-year Treasury yield fell roughly 3.6 basis points to about 4.76% Thursday, reversing some of the sharp rise seen earlier in the week.

That matters because Treasury yields are an important input into how investors value stocks.

When yields rise, safer bonds become more attractive and the discount rate applied to future corporate earnings increases.

That can put pressure on stock valuations.

When yields fall, some of that pressure disappears.

And that's exactly what investors saw Thursday.

The Dow Jones Industrial Average climbed about 1.2%, the S&P 500 gained roughly 1.0%, and the Nasdaq rose about 1.3% in the latest trading.

Technology and other growth-oriented stocks were among the beneficiaries.

But the Fed Isn't Out of the Woods

It's important not to overstate Thursday's rally.

Waller did not say the Fed is ready to cut rates.

He said he could support holding rates steady if inflation continues to improve.

That's a meaningful distinction.

The Fed's preferred inflation gauge remains above target. Waller noted that 12-month PCE inflation was 3.7% in July, while core PCE inflation was 3.3%.

Those numbers are still considerably higher than the Fed's 2% objective.

And energy prices remain another potential complication.

Crude oil prices have climbed amid renewed Middle East tensions, creating another potential source of inflation pressure.

If higher oil prices begin feeding into broader consumer prices, the Fed could have less flexibility to leave rates unchanged.

Tomorrow's Jobs Report Could Change Everything

Now investors have another major piece of data to digest.

The August employment report is due Friday.

Waller said he expects the labor market data to remain broadly consistent with recent trends, but the report could still have a significant impact on market expectations.

A surprisingly weak jobs report could strengthen the argument for keeping rates unchanged.

A stronger-than-expected report, particularly if accompanied by signs of renewed wage pressure, could make the Fed more comfortable keeping policy restrictive.

Then comes another potentially even more important release:

August inflation data on September 11.

That report arrives just days before the Fed's September 15-16 meeting.

In other words, investors now have two major data points that could determine whether Thursday's rally continues or reverses.

The Market Has Changed Its Mind Before

This week's moves are a reminder of just how quickly interest-rate expectations can change.

Earlier in the week, global bond markets were under significant pressure as investors worried about inflation, government borrowing and the possibility of higher rates.

The 10-year Treasury yield had climbed toward multi-year highs.

Then one Fed official suggested that the central bank could simply wait.

Suddenly, yields fell and stocks jumped.

That tells investors something important:

Markets aren't necessarily trading on where rates are today. They're trading on where they think rates are going next.

And right now, that expectation is changing by the hour.

What Comes Next

Thursday's rally gives stock investors some breathing room, but the bigger test is still ahead.

If Friday's jobs report comes in soft and next week's inflation data continues to show improvement, expectations for a September rate hike could fall even further.

That could push Treasury yields lower and provide another tailwind for stocks.

But if inflation surprises to the upside, the market could quickly reverse Thursday's move.

For now, Wall Street has received a much-needed reprieve.

The question is whether the data will give investors a reason to keep celebrating.