There is plenty of evidence that U.S. markets are all about the Fed right now. We see two sides lining up when it comes to where Fed policy is headed, and our models suggest getting less “growthy” by focusing on the Fidelity Equity Dividend Income Fund (FEQTX), explains Brian Kelly, editor of MoneyLetter.

When economic and inflation reports come in “hot,” the markets move as traders try to figure out the Fed’s next action. When the meeting minutes come out, every word is dissected, and the markets react. And when Fed Open Market Committee (FOMC) members speak, the markets move.

Here are the two sides to this battle as we see it:

1) The Fed has basically done enough. This side argues that we should see two (or maybe three) additional, small (25-basis point) increases this Spring, and that’s it. Interest rate hikes come with a lag effect, and we are near the time to wait and see what the overall effect of all the Fed’s work will be. The resilience of the economy up to now has demonstrated that it will plow through the inflation fight and come to a soft landing.

2) The Fed has been backed into a corner by the economy’s surprising resilience. Zacks says the US economy is “defying expectations,” which means the Fed is now forced into additional hikes beyond the recent consensus.

Also, in this scenario the Fed will likely hold rates “higher for longer” to get the desired slowing that many feel is needed to wrestle inflation back toward the 2% target. The result of this path, we feel, is a hard landing which will cause significant disruption in equity and bond markets.

We continue to favor scenario #1. While we don’t think the lag time for past rate hikes has been fully accounted for by the markets, it will be by the Fed. Expect inflation to decline enough to allow the Fed to pause after June and evaluate the data.

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What they’ll see, we believe, will be economic slowing for sure, but either no recession or a shallow one that allows the economy to muscle its way through this period of high inflation without a huge negative effect on corporate earnings and consumer activity.

If the Fed pauses and the soft-landing develops, that will be a good environment for stocks and bonds.

Recommended Action: Buy FEQTX.

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