Bull Market Rally Continues Despite Hawkish Fed: What to Do Now?

Stocks on Wall Street are on track to end the week with strong gains, with the S&P 500 and Nasdaq Composite both rallying to their best levels since August 2022 in the aftermath of the Federal Reserve policy decision.

The tech-heavy Nasdaq has been the best performer of the three major U.S. indices this year, surging 31.7% year-to-date.

That compares to an increase of 15.7% for the benchmark S&P 500 and a 4% gain for the blue-chip Dow Jones Industrial Average.

DOW, S&P 500, Nasdaq YTD Chart

That said, there appears to be a growing risk that the Fed will raise rates to levels above where markets currently anticipate, resulting in a correction over the near term.

A ‘Hawkish Pause’

The Fed held off on raising interest rates on Wednesday for the first time since its historic campaign to cool inflation began in March 2022. Fed policymakers unanimously voted to keep the target range for the federal funds rate at 5% to 5.25%.

The pause followed 10 straight hikes in 15 months, including four outsized increases of 75 basis points last year, followed by a half-point increase and then three quarter-point hikes this year.

U.S. Interest Rates Long-Term Chart

By skipping a rate hike in June, Jerome Powell and other top Fed officials hope to use the extra time to further assess how higher rates have affected inflation and the economy.

“Holding the target range steady at this meeting allows the Committee to assess additional information and its implications for monetary policy,” the Fed’s post-meeting statement said.

More Rate Hikes on the Way

In a surprisingly hawkish twist, the Fed’s policymakers issued projections showing they foresee at least two more quarter-point rate hikes over the remaining four meetings this year.

According to the latest dot-plot, most FOMC members are now projecting the fed funds rate will peak at a new target range of 5.5%-5.75%, half a percentage point higher than when comparable forecasts were published in March.

Fed officials also predicted that the benchmark rate will stay higher for longer than they predicted three months ago.

“Nearly all committee participants view it as likely that some further rate increases will be appropriate this year,” Fed Chair Powell said in his post-meeting news conference.

He added:

“Inflation has moderated somewhat since the middle of last year, nonetheless, inflation pressures continue to run high and the process of getting inflation down to 2% has a long way to go.”

Powell noted that the July meeting will be a “live” one, sending a strong hint that the Fed will deliver a rate hike next month.

In my view, the statement sends a clear message: “We are not done yet.” As such, I expect the Fed to move by 25bps in July and then hike another 25bps in September.

Inflation Remains a Sticky Point

Inflation may be cooling — just not yet fast enough for the Federal Reserve.

U.S. consumer price inflation in May rose 4% from a year ago, the smallest annual increase since March 2021.

While inflation has fallen significantly from a peak annual rate of more than 9% last summer, it remains at a level double the Federal Reserve's target of 2%.

U.S. Consumer Price Inflation

More worrying is that excluding volatile prices for energy and food, core inflation is still running at an exceptionally high level of 5.3%.

U.S. Core CPI

The core figure is closely watched by Fed officials who believe that it provides a more accurate assessment of the future direction of inflation.

"We understand that allowing inflation to get entrenched in the U.S. economy is the thing that we cannot allow to happen for the benefit of today's workers and families and businesses but also for the future," Powell stressed.

As such, the case to keep hiking remains strong.

Fed Rate Monitor Tool

As of Friday morning, investors currently anticipate a 72% chance of a 25-basis point rate hike at the Fed’s July 25-26 meeting, according to the Investing.com Fed Rate Monitor Tool.

What to Do Now

A hawkish message from the Federal Reserve amid a powerful stock market rally is presenting investors with a dilemma: how to maintain exposure to rising equities while also protecting against the possibility of a looming correction.

While I have been adding to my equity positions during the current rally, I plan to reverse that stance and head to the sidelines if the trend starts to change and the market starts to turn.Overall, it’s important to remain patient, and alert to opportunity. Not buying extended stocks, and not getting too concentrated in a particular company or sector are still important.

Taking that into consideration, I used the Investing Pro stock screener to build a watchlist of high-quality stocks which are still undervalued amid the current market environment.

Not surprisingly some of the names to make the list include Alphabet (NASDAQ:GOOGL), UnitedHealth (NYSE:UNH), ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), Merck & Company (NYSE:MRK), Pfizer (NYSE:PFE), Cisco (NASDAQ:CSCO), and Qualcomm (NASDAQ:QCOM) to name a few.

InvestingPro Screener Screen

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Disclosure: At the time of writing, I am long on the S&P 500, and the Nasdaq 100 via the SPDR S&P 500 ETF (SPY), and the Invesco QQQ Trust ETF (QQQ). I am also long on the Technology Select Sector SPDR ETF (XLK). I regularly rebalance my portfolio of individual stocks and ETFs based on ongoing risk assessment of both the macroeconomic environment and companies' financials.

The views discussed in this article are solely the opinion of the author and should not be taken as investment advice.