The set-up for Fed's October meeting
The FOMC is set to meet on Wednesday October 28th. The expectations are that the Fed will leave the Federal Funds rate unchanged at the current level of 3.75-4.00%, based on the Federal Funds futures with the implied probability of 92%.
The October FOMC meeting follows the first ( unanimous) Fed hike in September. The Fed signaled another hike for 2026. These two cumulative hikes are supposed to be the "insurance hikes".
The implication is that inflation is still not a problem, but it could become a problem, so these two hikes are necessary to make sure inflation does not become a problem. This thesis is supported by market inflation expectations embedded in 10Y yields, with the Breakeven inflation around 2.35%, well below the critical 2.5% level.
However, the Fed's "insurance hikes" framework has been challenged by the market participants, who price additional 2-3 hikes in 2027, based on the Federal Funds futures.
In other words, market participants price the inflation regime hiking cycle, not just the two insurance hikes. The implication is that market participants believe that inflation is already a problem, so the Fed has to do more than just two cumulative insurance hikes.
So, that's the set up for the Fed's October meeting. The Fed thinks one additional hike is necessary, while the market calls for an additional 2-3 hikes deep into 2027.
However, the situation is now more complex. The AI bubble seems to be bursting - and this could cause a recession. Thus, the Fed's focus has to shift first to financial stability, and then to a recession, which means the Fed's next move is likely a cut, possibly as early as next week.
Regime change
I warned on October 14th about a possible regime change after the hot CPI inflation report release - with direct implications for the Fed's policy path.
So, the core CPI came in higher than expected, and the headline CPI rose to 3.7%. The bond market initially sold off as expected, with 10Y yields (US10Y) rising to 5.30% and 2Y yields (US2Y) rising almost to 5%, but then the news broke-out about the advances of Chinese chipmaker CXMT and the debt worries about CoreWeave (CRWV) resurfaced.
The bond market reversed the selloff, and interest rates subsequently fell. At that specific point the bond market started to price the AI bubble burst, with a recession. This was the first signal of the regime change.
The implied Federal Funds rate for the December 2026 contract was 4.20% right after the CPI report on October 14th, and currently it's at 4.01%. This means that the market was pricing possibly 2 additional hikes in 2026, and now it's pricing possibly no hikes at all.
However, if the AI bubble bursts and accelerates, the Fed is likely to start cutting interest rates, possibly as early as next week.
Is the AI bubble bursting?
The AI bubble seems to be bursting. Specifically, 1) the expected AI capex seems to be unrealistic and financially unsustainable, 2) the AI adoption is not producing the required ROI to support further AI spending, and 3) credit spreads are spiking for AI companies, with some struggling with heavy debt levels and negative free cash flows.
Here is the most recent evidence: IBM (IBM) warned that "larger enterprises are a lot more aware of what the true ROI of all of their AI spend," while Meta (META) delayed the ROI on AI investments to "longer-term." At the same time the credit concerns about CoreWeave are intensifying.
The evidence of the AI bubble burst can be tracked by the performance of semiconductors (SMH), the main beneficiaries of AI capex. Technically, the chart below shows a classic melt-up, a double top with a lower high, currently at the key neckline support line, which is also the key 200dma support. If the 200dma support breaks, the AI bubble burst is likely to accelerate. Note, this technical breakdown is supported by fundamentals, as previously explained, which makes it more likely.
Will the AI bubble burst cause a recession?
The AI bubble burst is very likely to trigger a deep recession, for these three main reasons:
AI capex has been the main driver of US GDP growth, and if AI capex slows, the economy will likely slow significantly.
Consumption has also been very strong, primarily due to the wealth effect, which is primarily due to the bubble in AI stocks. Once the AI bubble bursts, a negative wealth effect will likely reduce consumption and contribute to the recession.
The AI adoption has not resulted in major job losses yet. However, as the recession hits, companies will be forced to reduce costs, and at that point there will be likely more job losses due to AI, and this will also contribute to the recession.
Overall, the AI trade has supported the US economy and the US stock market, without a significant negative effect on the US job market. The AI bubble burst will reverse these effects and trigger a recession.
Implications for the Fed
The data is still showing a very tight labor market, and rising inflation. In addition, we are also facing an unfolding inflationary oil price shock, and all indications are that the situation in the Middle East will escalate after the midterms.
Thus, based on the current macro situation, the Fed should be hiking more aggressively to invert the yield curve - the Fed should hike next week, and in December, and 3-4 more times in 2027 to at least 5.5%.
Yet, these are all lagging indicators or transitory inflationary effects (oil). The leading indicator is the stock market, and the AI stocks. Thus, if the AI bubble continues to burst the Fed will likely ignore the rising oil prices and focus on financial stability. This is similar to the situation in the first half of 2008 when oil (CL1:COM) spiked to $150/barrel, but the Fed was still cutting in response to early signs of the 2008 financial crisis.
With that said, the S&P500 (SPY) could plunge sharply and quickly, especially if the 200dma support is broken for SMH - and if this happens over the next few days, the Fed could even cut rates as early as next week, invoking the financial stability mandate.
Obviously, the S&P500 (SP500) would need to plunge by 10% or more over the next few days, which is not impossible, but it's unlikely.
Also, obviously, if the AI stocks stabilize and rebound, the Fed would be back in the inflationary regime - and this means a hike is possible next week given the recent inflation data. However, fundamentally, I don't see how the AI concerns could ease. Thus, I see a dovish pause as more likely.
My prediction
I think we are in a period similar to early 2008 when the price of oil was rising, but the early signs of the financial crisis forced the Fed to cut rates.
Currently, credit spreads are already spiking for CCC rated bonds or below, and some AI related debt is already trading at distress levels. These are the first cracks. Thus, in my opinion, the Fed will likely shift the focus to financial stability and turn dovish.
The Fed will likely leave the Federal Funds rate unchanged next week, but the next move will likely be a cut in December, as I expect that the AI bubble burst will accelerate.
Implications for investors
The S&P500 has likely peaked, and we are likely in the early stages of a bear market. The drawdown could be significant, at par with the 2000 and 2008 bear markets.
The US dollar (DXY) is likely in a process of peaking, and eventually the debasement trade will return as the Fed turns dovish, which should benefit Gold (GLD).
Thus, I this moment still favor short term treasuries (BIL), with an eye on precious metals. Utilities (XLU) generally benefit from lower rates, but XLU is part of the AI capex beneficiary trade, so I would avoid it as a safe heaven.
Source: Seeking Alpha