Multiple risks are raising the stakes in financial markets and for the U.S. economy as Federal Reserve policy makers prepare to gather this week.

The Fed is widely expected to deliver a quarter-of-a-percentage point interest rate hike when its meeting concludes on Wednesday. The most crucial question facing investors is whether policy makers subsequently show a willingness to hold off on further rate rises in order to assess the damage from their year-long campaign to lower inflation.

If they do pause, it may be time for investors to jump back into equities and bonds, both of which could rally over the next six months, said Brian Jacobsen, a senior investment strategist at Charlotte, North Carolina-based Allspring Global Investments, which managed $463 billion as of December.

Not everyone agrees, though: Wall Street veteran David Rosenberg points out that history shows such a shift in Fed policy doesn’t guarantee a stock rally.

In just the past week alone, investors have seen fresh signs of sticky inflation even as the U.S. economy grew at a soft 1.1% annual pace in the first quarter, while concerns have flared over the U.S. debt ceiling, and jitters about the banking sector re-emerged as the result of a $100 billion drop in deposits at San Francisco’s First Republic Bank in March.

All this comes at a time when traders expect policy makers to deliver their 10th straight interest rate hike on Wednesday which would push the fed-funds rate above 5% to its highest level in almost 17 years.

The Fed’s rate hikes, which began in March of last year, sparked a 2022 rout that slammed both stocks and bonds, pushing the S&P 500 SPX, +0.83% into a bear market that it has yet to exit. However, because much of the fallout seen so far in the banking sector and the U.S. economy is part of a Fed-engineered slowdown, investors have tried to take it in stride. The large-cap benchmark, the Dow Jones Industrial Average DJIA and Nasdaq Composite COMP remain higher for the year to date.

What still has many investors and traders rattled, though, is the speed with which policy makers have delivered almost 5 percentage points of hikes, producing worry about a range of potential worst-case outcomes.

Those scenarios include the prospect that the U.S. economy may be settling into a period of stagflation combining slower growth combined with high inflation, or may be heading into a steeper downturn accompanied by more layoffs at a time when stress in the banking sector could spread and there are fears of a potential default if Congress is unable to raise the $31.4 trillion debt ceiling.

Jefferies Group, one of the two dozen primary dealers that serve as trading counterparties of the Fed’s New York branch, is sticking by its long-held view that U.S. economic growth will slow substantially in the second quarter before contracting in the second half of the year, according to U.S. economist Thomas Simons.

“This is a rather inopportune time for the Fed to be considering another hike because we have concerns about a recession, stubborn inflation, a banking crisis unfolding before our eyes, and political dysfunction keeping Congress from raising the debt ceiling,” said Jacobsen of Allspring Global Investments based in North Carolina. “We’re on a knife’s-edge moment: Things could either resolve themselves nicely or we will have quite negative outcomes from any one of these factors.

“The wild card is political and it could be the 11th, 12th, or 13th hour before there is an agreement on the debt ceiling,” Jacobsen said via phone.

Allspring is avoiding making “big direction bets on the market” in favor of relative-value trades in its multi-asset portfolios, and is adding more 10-year government-bond futures TY00, -0.05% on the view that “the risks to the U.S. will ultimately resolve themselves,” he said. Meanwhile, there could be “big-time volatility in markets, whether in equity prices or credit spreads jumping up or down.”

Financial markets have settled into a wait-and-see posture ahead of the Fed’s policy decision. U.S. stocks ended higher on Friday, with the Dow Jones Industrial Average booking its best monthly gain since January. Oil prices also rallied. Meanwhile, gold ended the month with little fanfare and Treasury yields finished broadly lower for the day and the week.

Friday’s data showed that inflation based on the Fed’s preferred price gauge barely rose in March, although the narrower measure that strips out volatile food and energy remained sticky. The report came a day after Thursday’s first-quarter GDP report revealed that the economy is slowing, but the much-predicted U.S. recession hasn’t arrived because consumers are still confident enough to keep spending.

Alexandra Wilson-Elizondo, co-head of portfolio management for multi-asset solutions at Goldman Sachs Asset Management, said the GDP report data suggests “that we are in the ‘bend, not break’ phase of the cycle.”

“This next Fed meeting is an important one because if policy makers raise rates by 25 basis points and don’t signal a pause, markets are not going to like this,” said Greg Faranello, Head of U.S. Rates at AmeriVet Securities in New York, a veteran-owned broker dealer. “I think they should take the last 25 and stop to evaluate things.

”The real economy has held up fairly well, even though there are some signs of things cracking and breaking down at regional banks,” Faranello said via phone. “The question is whether there is already enough collateral damage or more minefields that are likely to surface going forward.”

According to Faranello, investors may need to be prepared to sit on the sidelines and remain parked in cash until they get a clearer answer on the question about whether policy makers would be willing to pause.

Despite the relative calm in financial markets in April, March may offer an example of the type of volatility that could resurface in the second quarter and heading into the second half, market watchers said. In March, markets abruptly swung from a higher-for-longer view on interest rates to the potential for rate cuts to avert a deep recession and repeated bank failures. Nervousness spiked across asset classes, as measured by the Cboe Volatility Index VIX, +3.61%, a measure of expected S&P 500 volatility; the ICE BofAML MOVE Index of implied volatility in the bond market; and Credit Default Swap Index, or CDX, that tracks U.S. and emerging-market credit-default swaps.

The VIX and MOVE indexes have since fallen back, with the former trading at its lowest since November 2021, according to FactSet.

For Allspring’s Jacobsen, the Fed’s best course of action would be to pause its rate hikes on Wednesday, even though fed funds futures traders see that as unlikely. Instead, they’re factoring in an 84% chance of another quarter percentage point hike. He said that a surprise “hawkish hold” by the Fed — or pause accompanied by a signal to remain vigilant in the fight on inflation — would be the move that would most stabilize financial markets.

Wednesday’s 2 p.m. Eastern time policy statement by the Fed and 2:30 p.m. news conference by Chairman Jerome Powell are the highlights of the week ahead.

Monday brings the release of April manufacturing data from the Institute for Supply Management, and construction spending for March. On Tuesday, March data on U.S. job openings and factory orders are released.

Ahead of the Fed’s policy decision on Wednesday, the ADP private-sector employment report and ISM service sector activity data are set to be released. Thursday’s data batch includes figures on first-quarter productivity, the March U.S. trade deficit, and initial weekly jobless claims.

Finally, Friday brings the U.S. employment report for April.