Why a Fed rate-hike pause may not be as great for stocks as Wall Street hopes

The possible end to the Federal Reserve's long campaign of rate hikes appears like an oasis to beaten-down Wall Street investors, but is it a mirage?

With inflation cooling from its peak last summer, Wall Street overwhelmingly assumes the central bank will hold rates steady for the first time in more than a year when it meets next month.

High rates knock down inflation by slowing the economy, raising the risk of a recession and hurting prices for all kinds of investments.

The stock market has held steady in recent weeks as investors bet on a pause by the Fed, offsetting a long list of other concerns, from cracks in the US banking system to the US government's edging toward what could be a catastrophic default on its debt.

History seems to be on Wall Street's side. Going back to the 1980s, the S&P 500 has jumped an average of nearly 6 per cent in the three months after the Fed makes its final increase in a rate-hike campaign.

But something makes today different than those four times: how bad inflation is. Inflation was still 4.9 per cent in April, way above the Fed's 2 per cent target.

That may make today's scenario more like the rate-hike campaigns that ended in 1969, 1973 and 1981. The S&P 500 fell by an average of 6.6 per cent in the three months following the final rate hike in those episodes, according to strategists at Morgan Stanley.

The difference may be that when inflation is elevated, the Fed may need to keep rates on hold for a long time. When inflation is lower, meanwhile, it can more quickly begin cutting rates, something that acts like steroids for financial markets.

Traders have already built bets for the Fed to cut rates later this year, while the Fed has said it expects none if things go according to plan.

"I think rate cuts are something more like a 2024 story," said Megan Horneman, chief investment officer at Verdence Capital Advisors. "Right now markets are pricing in some chance of a rate cut as early as this summer."

That may be setting already pricey stocks up for drops if those expectations aren't met, she said.