Article Summary:

• Analysis of the impact of the October FOMC meeting on financial markets.
• Examination of various scenarios, including a 25 or 50 basis point rate cut or no change.
• The impact of Federal Reserve statements on stocks, gold, and the cryptocurrency market.
• The role of alternative economic data in making monetary policy decisions.
• The impact of a potential government shutdown on the economy and markets.

Year-to-date, US equities have been buoyed by tech-led optimism, particularly in AI-related stocks like Nvidia. The market has shrugged off concerns about a potential government shutdown, but anxiety is mounting ahead of the October Federal Open Market Committee (FOMC) meeting.

The Federal Reserve will face the challenge of setting monetary policy in the absence of complete government data. This raises questions about how central banks make decisions under such circumstances.

This has happened before, during the longest government shutdown in US history (2018-2019). At that time, the Fed relied on alternative data from the private sector and market indicators.

But the stakes are higher this time, as the US economy is slowing, fiscal policy is in disarray, and monetary policy is tightening. A wrong decision could disrupt markets, unnecessarily tighten financial conditions, or accelerate inflation.

Current discussion centers on whether the Fed will cut interest rates by 25 basis points. The market expects this scenario, but the language used by the Fed will be crucial.

If the Fed cuts rates while maintaining a hawkish tone, the market could see a broad sell-off. Stocks may rise initially due to the rate cut, but the Fed's concerns about persistent inflation will push up real bond yields and the US dollar, hurting growth stocks. Gold will also fall, and highly leveraged positions will be liquidated.

Conversely, if the Fed cuts rates by 25 basis points with a dovish tone, the market may see that the easing cycle has just begun. If Fed Chair Powell and his team emphasize downside risks - including a weak labor market or a weak global economy - stocks will rise sharply, the dollar will fall, gold will rise, and the market's risk appetite for stocks and cryptocurrencies will soar.

This is the "soft landing + monetary easing" scenario that bulls are betting on.

The Fed may take a bolder action - cut interest rates by 50 basis points. But the Fed will only do so if private data shows that the economy is deteriorating at a faster-than-expected pace, or if financial markets are in trouble.

Such large-scale intervention would signal the Fed's recognition that the economy faces an imminent risk of recession or credit distortions. If accompanied by dovish statements, risk assets (stocks, cryptocurrencies, gold) will almost universally rise, and the market will end up in a state of mania. But this bold move may also trigger panic - investors will speculate that the Fed is aware of a crisis that the public is unaware of, and defensive rebalancing may occur after the initial rise, especially as investors begin to look for signs of systemic weakness.

There is another outcome that is not discussed enough: the Fed may keep interest rates unchanged, but issue dovish guidance. This is a classic "wait and see" strategy, especially if there is too much delayed economic data due to the government shutdown, making it impossible to take immediate action. The Fed may actually say, "We are not cutting interest rates at this time, but we are ready to cut them if things get worse." Whether the stock market will accept this position depends on the credibility of the guidance; but if the market interprets the pause as concern or hesitation, volatility will rise sharply.

Finally, there is the market's "doomsday scenario": the Fed keeps interest rates unchanged and issues hawkish signals. Such a signal would make sense if inflation data remains high in the Fed's alternative tracking metrics, or if wage growth and housing inflation are not slowing fast enough.

If Powell mentions phrases such as "persistent inflation," "premature easing," or "too easy financial conditions," the market will interpret this as "there will be no rate cuts in the near future." At that time, the S&P 500 may fall sharply, the dollar will rise, gold will fall, and highly leveraged trades will face extreme difficulty.

The Fed's statements are more important than ever. Because official unemployment rate, Consumer Price Index (CPI) and wage data may be missing, Powell may rely more on the Institute for Supply Management (ISM) surveys, initial jobless claims, market-based inflation expectations, etc. of "soft indicators". But the problem is that these alternative indicators are often volatile and have a lagging effect. The risk is that if Powell's statements are too conservative compared to the data that is eventually released, or are more hawkish than investors expect, the market reaction may be very violent.

The Political and Policy Game

In addition to the necessity of the policy itself, political factors are increasing market frenzy. The longer the government shutdown lasts, the more friction it causes to the economy. Delays in paying federal employees, delayed contracts, and stalled construction projects - these secondary effects will gradually be reflected in corporate profits, consumer data, and market sentiment.

In the current tense situation, even a rate cut by the Fed may not be enough to calm concerns. Investors need to actively prepare for all possibilities, rather than just focusing on expected scenarios. This means closely tracking real bond yields, volatility indices, and foreign exchange positions.

In an asymmetric environment, gold remains one of the best hedging tools, especially when the Fed over-adjusts or fails to control the market narrative. Stock investments need to be selective, avoid chasing indices, and focus on companies with pricing power, a strong balance sheet, and low interest rate sensitivity.

The Fed's job has never been simple, and when it has to guide the world's largest economy in the absence of complete "dashboard tools," the difficulty increases exponentially. The market expects the economy to achieve a soft landing, and whether the Fed will support or shatter this expectation depends on "what it says," not "what it does."

The author is Naeem Aslam, Chief Investment Officer at Zaye Capital Markets in London.