The Federal Reserve interrupts Trump's "spell," will the catalyst for a correction in the U.S. stock market take effect?

After recording the best weekly performance of 2024, the U.S. stock market encountered a setback. The soaring stock market since Trump's victory in the presidential election on November 5 may indeed have been due for a correction, with the only question being what the catalyst would be.

Federal Reserve Chairman Jerome Powell stepped up last Thursday in Dallas. He reminded investors that, in the face of a resilient economy, the Fed is not in a hurry to make the next rate cut, a tone that was largely consistent with his remarks at the press conference following the Fed's rate cut on November 7, when rates were cut by 25 basis points following a 50 basis point cut in October.

However, investors seemed to hear a different message, one that neither promoted the excitement that immediately followed the election nor raised concerns about the Fed's future rate-cutting pace and market interest rate trends. These considerations, along with the potential impact of Trump's economic plan, may influence market trends in the coming weeks.

Before Powell made his remarks, U.S. inflation data released earlier last week was still slightly stronger than expected. Meanwhile, other Fed officials also made it clear that a rate cut in December is not a foregone conclusion. Following Trump's victory, U.S. Treasury yields have accelerated upward, and the stock market quickly felt the pressure.

Larry Adam, Chief Investment Officer at Raymond James, stated in a report last Friday, "So far, the market has ignored the rise in U.S. Treasury yields. The S&P 500 has risen 6% since the 10-year Treasury yield bottomed out two months ago. However, if the 10-year Treasury yield breaks above 4.5%, the stock market may face pressure and correct in the near term."

In trading last Friday, the 10-year Treasury yield did briefly break above 4.5%, then seemed to attract buyers, closing the day near 4.46%.

Adam believes that "as long as the upward trajectory of corporate earnings remains intact and the economy achieves a soft landing," Treasury yields will not become a persistent issue for the stock market.

However, BMO Capital Markets interest rate strategists Ian Lyngen and Vail Hartman stated in a report that stock market investors may still be influenced by fluctuations in the bond market in the short term.

They wrote, "The feedback loop between rising Treasury yields and stock market volatility will be a focus in the coming trading days. In the absence of other reasons, the lack of any top-tier data will make investor sentiment susceptible to fluctuations in other asset classes."

The outlook for Treasury yields depends on investors' ultimate views on Trump's economic plan. Analysts have been debating to what extent the rise in Treasury yields since late September has been driven by concerns over Trump's reflationary policies, including import tariffs, tax cuts, and ongoing government deficit spending.

Powell reiterated that policymakers will not make assumptions about fiscal policy and other measures, but Fed watchers and interest rate strategists want to know whether the uncertainty surrounding Trump's agenda is prompting the Fed to want to retain more options regarding the speed and scope of further rate cuts. Krishna Guha, head of the Global Policy and Central Bank Strategy team at Evercore ISI, stated in a report last Friday that Federal Reserve officials "are already considering potential re-inflation shocks, the equilibrium inflation rate, changing financial conditions, and reduced visibility on the economic outlook through 2025."

He wrote, "We believe this makes them more sensitive to upside surprises in inflation data, while also increasing their concerns about the 'data dependency' related to Trump that cannot be publicly discussed."

Guha indicated that the current situation remains consistent with expectations that the Federal Reserve will cut rates by another 25 basis points in December. He anticipates that by 2025, the Fed will slow to a rate cut of 25 basis points each quarter, ultimately bringing the federal funds rate down to 4%, but the timing and scope of rate cuts are more uncertain. This should marginally suppress investor interest in risk assets.

"Even in our baseline forecast, the Fed will prioritize selectivity to hedge against the uncertainty brought by Trump," Guha wrote. "When the Fed holds long option positions, risk-seekers hold short option positions, so even if the baseline scenario is not as hawkish as some fear, it is not particularly favorable for risk assets."