By Lewis Krauskopf
NEW YORK, Sept 11 (Reuters) - Investors head into next week's Federal Reserve unclear about the prospects that the central bank will hike interest rates, a move that could threaten a U.S. stock market rally already showing some vulnerability to rising bond yields.
For years, inflation has persistently run above the Fed's 2% annual target, and interest rate increases are the primary tool the central bank has historically deployed to try to tamp down prices.
After last month's speech
from new Fed Chair Kevin Warsh that was widely perceived as hawkish, bets have grown that the Fed will hike rates at the end of its two-day meeting on Wednesday. Some investors remain dubious that the central bank, which has held rates steady so far in 2026, will take that step.
"It's kind of a razor's edge," said Alicia Levine, chief investment officer at BNY Wealth. "This is the first meeting in a long time where it's felt, wow, it really could go either way."
Higher interest rates could undercut stock performance in several ways, including by raising borrowing costs for consumers and companies. Rate hikes that translate into higher Treasury yields could create more investment competition from bonds and pressure equity valuations.
The benchmark S&P 500 is up about 11% so far in 2026, lifted by robust corporate earnings growth that has been boosted by massive spending on AI infrastructure.
The index has pulled back recently, hovering 2.7% below its mid-August all-time high. A selloff in the bond market has pushed U.S. Treasury yields to multi-year highs, with the benchmark 10-year yield closing in on a 5% level that could cause more trouble for stocks. Investors are also grappling with spiking tensions between the U.S. and Iran that this week pushed oil prices over $100 a barrel.
"We're at a period where there's a lot of uncertainty," said Cayla Seder, macro multi-asset strategist at State Street. "You have rising yields, and you have rising expectations of hikes... There is some overall nervousness that has to be priced into the market."
MARKET ODDS LEAN TOWARD QUARTER-POINT HIKE
Fed funds futures on Thursday were suggesting a roughly 70% chance the central bank raises its rate of 3.5%-3.75% by a quarter-percentage point, according to LSEG data.
Those odds have shifted up and down in recent weeks, as traders reacted to economic data and comments from Fed officials. The latest employment report showed surprisingly strong monthly job gains, bolstering the hike odds.
The latest reading of the core Personal Consumption Expenditures Price Index, which Fed officials use as a guidepost for inflation's underlying run rate, came in last month at 3.3% on an annual basis.
"We know inflation is above target, we know that unemployment is low," Seder said. "If the Fed does not hike and you see the market rally off of that, I think that could be an opportunity to fade a little bit. Because there's still this looming environment where, maybe they don't hike in September, but they could at a later date."
WOULD ONE HIKE START A CYCLE?
If the Fed does hike on Wednesday, investors said they will look for signs about whether it is likely to be an isolated move or the start of a series.
"If it signals a cycle -- like, hey, we still have work to do... -- I don't think it's going to be great for the market," BNY's Levine said.
Some investors said Wednesday's Fed decision could be a test of Warsh's inflation-fighting credibility, which came under scrutiny following his press conference at the last Fed meeting in July.
"The market remains concerned a bit with respect to Fed independence," said JP Coviello, head of portfolio strategy at Citi Wealth.
BENCHMARK YIELDS KEEP PUSHING HIGHER
Rate hikes could filter through to bond yields, which have climbed steadily higher in recent weeks and led to some turbulence in equities. The 10-year Treasury yield rose to 4.96% on Thursday, its highest level in nearly three years.
Rate hikes and higher yields could particularly have ripples below the market's surface, investors said. Rate-sensitive areas could struggle more, such as shares of smaller companies that tend to rely more on debt financing.
Citi's Coviello said the rise in yields has stemmed from "good reasons," namely the pickup in economic growth expectations, while the strong earnings performance underscores a solid fundamental backdrop for stocks.
"Given the rate of change in earnings growth that we're seeing at the corporate level, in our view, that outweighs the rise in real yields from an equity investment perspective," he said.
(Reporting by Lewis Krauskopf, editing by Colin Barr and David Gregorio)
