It's Impossible to Get Rid of Bets on a Big Fed Rate Cut. Stock Markets Are at High-Stakes

The Federal Reserve is poised to announce an interest rate cut at the end of its policy meeting on Wednesday, but there is significant uncertainty regarding the size of the cut. Fed-funds futures traders have priced in an almost equal probability of a standard 25 basis point reduction versus a larger 50 basis point cut. This decision has sparked debate over whether a significant rate cut might either calm or further alarm investors concerned about a slowing economy potentially tipping into a recession, threatening corporate profits, and undermining a two-year bull market.

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Kathy Jones, the chief fixed-income strategist at the Schwab Center for Financial Research, noted that, over the past decade, investors usually had a clear indication of the expected rate move ahead of Fed meetings. However, this time, the situation is markedly more ambiguous. Jones remarked that the current fixation on whether the cut will be 25 or 50 basis points has become "a little crazy."

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On Friday afternoon, fed-funds futures traders assigned a 47% chance to a 50 basis point cut, an increase from 28% the previous day, while a 25 basis point cut was still the slightly more likely scenario, with a 53% probability, according to the CME FedWatch Tool. With three more Fed meetings scheduled in 2024, including Wednesday's, traders are anticipating a total of 100 basis points in cuts by the end of the year. This suggests that at least one of those meetings could feature a 50 basis point reduction.

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The concern lies in the historical context of larger rate cuts, which have typically been reserved for severe economic conditions. It is unclear whether a 50 basis point cut now would signal to investors that the Fed is aware of underlying economic dangers not yet apparent to the public. However, Jones argues that with the current fed-funds rate at 5.25%-5.5% and inflation running at 2.5%, there is ample room for the Fed to cut rates without reigniting inflation. "I’m in the camp that says, why wait,” she stated, suggesting that a 50 basis point cut would bring the fed-funds rate below 5%, still reflecting a tight monetary policy.

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Jones also emphasized that the market's reaction will be heavily influenced by the Fed's guidance on the path of future rate cuts following Wednesday’s decision. A significant initial cut of 50 basis points, paired with signals that future cuts would proceed in smaller 25-point increments through the Fed’s dot plot forecast, could reassure markets. Further remarks from Fed Chair Jerome Powell that highlight the room for front-loading rate cuts due to restrictive policy and the faster-than-expected drop in inflation would also help soothe market nerves.

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Conversely, a smaller, standard 25 basis point cut could unsettle investors who fear that the Fed is not acting swiftly enough, said Charlie McElligott, managing director of cross-asset strategy at Nomura. If traders are still expecting a more substantial move, "anything but 50bps will [disappoint] market pricing, hence acting to tighten [financial conditions] in de facto ‘hawkish’ –fashion," he wrote.

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There are, however, seasoned market participants who believe that starting a rate-cutting cycle with a large move could make investors worry about hidden economic threats. In past easing cycles since 1990, the Fed has only begun with a 50 basis point cut twice: in January 2001, when the dot-com bubble burst and the economy was already skidding, and in September 2007, when early strains in the housing market signaled the onset of a major financial crisis. Nicholas Colas, co-founder of DataTrek Research, suggested that given this history, "Their first cut will almost certainly be 25 basis points," to retain flexibility for further actions if conditions worsen, particularly in the labor market.

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Kathleen Brooks, research director at XTB UK, offered another perspective, warning that a 50 basis point cut might be interpreted as a move to front-load rate cuts, which could lead to fewer cuts in the future, surprising the market and potentially weighing on risk sentiment.

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The varying opinions underscore the complexity of the Fed's decision-making process and the uncertain market reaction. This ambiguity persists partly because recent economic data, which was expected to clarify the situation, has not provided a definitive answer. Fed Chair Powell’s late-August speech indicated a focus on preventing a sharper deterioration in the labor market, but subsequent economic reports, including the August jobs data, have remained inconclusive.

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Meanwhile, stock markets have rebounded from early September losses, buoyed by a recovery in the technology sector. The Dow Jones Industrial Average gained 2.6% for the week, the S&P 500 rose 4%, and the Nasdaq Composite logged a 6% weekly gain. As investors await the Fed's next move, the key takeaway may be the commencement of a rate-cut cycle, which can either support or challenge equity markets depending on the broader economic environment.

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Kathy Jones of Schwab encapsulates the sentiment by suggesting that investors should focus less on the exact size of the rate cut and more on the "direction of travel" for interest rates, which appears to be downward. This insight can help shape investment strategies moving forward, regardless of the Fed's immediate decision.

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