Here's the real signal to watch for the Fed's next move

By Michael Kramer

Investors should focus not on the rate itself, but on where financial conditions are

Which way are rates going?

The Federal Reserve is not expected to raise interest rates at its meeting on Wednesday; however, it is expected to raise rates again before the year is over. Whether the Fed should raise rates is another question entirely, and most evidence suggests it should.

Financial conditions have begun to tighten, but they remain fairly loose. The Chicago Fed's National Financial Conditions Index is only -0.50, a historically low reading. When the financial conditions index rises toward zero, conditions are tightening; when it falls further below zero, or becomes more negative, they are easing.

The Chicago Fed's National Financial Conditions Index from 1987 to 2026, showing a massive peak during the 2008 financial crisis. It's currently at -0.50.

Financial conditions are loose

In 2022, financial conditions tightened significantly during the Fed's rate-hiking cycle, and it is reasonable to assume that if the Fed is serious about bringing inflation down to its 2% target, it will need to continue hiking rates until financial conditions become more restrictive. A move in the financial conditions index toward zero would indicate that monetary policy is having a greater impact. The limited tightening in financial conditions suggests the Fed should hike at this week's meeting, even though it probably won't.

Historically, the S&P 500 SPX and the financial conditions index have moved inversely, with rising stock prices generally associated with easing financial conditions. However, as the Fed tightens policy, financial conditions should become more restrictive, creating a less supportive environment for rising stock prices.

Comparing the Chicago Fed's National Financial Conditions Index (red and green) and the S&P 500 Index (blue line) from 1989 to 2026, and the correlation indicator (bottom red line).

Spreads remain low

One reason financial conditions haven't tightened is that credit spreads remain fairly low, which may also explain why stock prices seem unconcerned about the threat of a Fed rate-hiking cycle. Unlike the S&P 500, the ICE BofA US High Yield Index Option-Adjusted Spread has a positive relationship with the Chicago Fed's National Financial Conditions Index, and while credit spreads have risen, they also remain relatively low.

Comparing the Chicago Fed National Financial Conditions Index (red line) and the ICE BofA US High Yield Index Option-Adjusted Spread (blue line) from 2000 to 2026, and the correlation indicator (green line).

When credit spreads widen, implied volatility in the equity market tends to rise. This is one reason that tightening financial conditions can negatively affect equity prices. If expectations for additional Fed rate hikes lead investors to reassess credit risk, spreads could widen further, pushing implied volatility higher and putting downward pressure on equity prices.

Comparing the ICE BofA US High Yield Index Option-Adjusted Spread (black line) from 2017-2026 and the S&P 500 Volatility Index (blue line), and the correlation indicator (green line).

The idea is to tighten financial conditions enough to restrain inflation, which could eventually pressure equity prices. But given the equity market's performance over the past couple of years and the expansion of the price-to-earnings ratio, it's hard to argue that financial conditions have been particularly restrictive, except for a period in 2022.

What to watch for

Right now, fed funds futures price in the Fed raising rates from the current 3.75%-4% range to around 4.5% by the end of 2027. With another rate increase expected before the end of this year, the Fed's tone in its statement Wednesday and during Chair Kevin Warsh's press conference will matter. It won't be the policy action the Fed takes that tells us its direction, but the direction and tone it takes toward financial conditions.

If Warsh signals that financial conditions haven't tightened enough, it could reinforce expectations for additional rate hikes, resulting in the market pricing in more rate hikes than expected, and interest rates rising. This could potentially weigh on risk assets, widen credit spreads, and push implied volatility higher.

The key this week is thinking about the Fed's path through financial conditions, as Warsh referenced in his last press conference when explaining what the rate hike represents, which was the removal of accommodation from financial conditions. To gauge where the Fed goes from here, investors should focus not on the rate itself, but on where financial conditions are and whether they are tight enough to bring inflation back to target.

The stock market may be the simplest way to track that.

Michael Kramer is the founder of Mott Capital Management and a long-only investor focused on macroeconomic themes. He analyzes long-term macro trends and short-term market risk using technical analysis, fundamentals and options-market positioning. See here for further disclosures.

-Michael Kramer

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

10-25-26 0730ET