Market Sets Itself Up for Disappointment as It Hits All-time Highs Before Fed Decision

The Federal Reserve is widely expected to cut interest rates on Wednesday, but the stock market appears to be setting itself up for potential disappointment. Last week, investors anticipated a quarter-point rate cut and were content with the fact that the Fed was finally initiating its easing cycle. However, market dynamics have since shifted.

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In the past week, the stock market has surged to new heights, with both the S&P 500 and the Dow Jones Industrial Average reaching record levels during Tuesday's session. This rally reflects the growing optimism among traders, who now increasingly expect a more aggressive half-point rate cut from the Federal Reserve. This expectation contrasts with the general consensus among Fed officials and economists, who have largely anticipated a more modest quarter-point cut to kick off the central bank's rate-cutting cycle.

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As of Tuesday afternoon, the CME FedWatch Tool indicated that traders were pricing in a 63% probability of a half-point reduction, which would lower the federal funds rate to a range of 4.75% to 5%, down from the current 5.25% to 5.50%. Meanwhile, the likelihood of a smaller, quarter-point cut stood at 37%, suggesting a range of 5% to 5.25%.

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Just a week ago, the prevailing theory was that a half-point cut might trigger panic in the markets, hinting that the Fed possessed knowledge about the economy that was not yet reflected in market data. However, sentiment has since shifted from that fear to an expectation for a more aggressive easing stance. The evolving outlook suggests that traders have become increasingly comfortable with the idea of a larger rate cut, seeing it as a proactive move rather than a sign of hidden economic troubles.

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In a note released on Tuesday, JPMorgan traders expressed that a half-point cut could serve as a "clearing event," allowing the market to refocus on other significant factors, such as corporate earnings and the upcoming presidential election in November. From their perspective, a more substantial rate cut would not incite panic but would instead reassure the market, aligning with expectations for a more aggressive easing cycle in 2024.

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Michael Feroli, JPMorgan's chief U.S. economist, echoed this sentiment in an interview with CNBC's "Squawk on the Street" earlier this month. He argued that the Federal Reserve should expedite the pace of its rate cuts, saying, "We think there’s a good case for hurrying up in their pace of rate cuts." His comments suggest that a larger rate cut could provide the necessary impetus to address economic headwinds more swiftly.

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On the other hand, JPMorgan traders cautioned that a quarter-point cut could exacerbate market uncertainty. Such a move might temper the market's current rally, making it less likely that stocks would continue to build on their all-time highs. The traders noted that a smaller rate reduction would force the market to adjust its expectations for the remainder of the year and beyond. Specifically, if the Fed opts for a 25-basis-point cut, traders would have to revise their outlook for year-end 2024 easing, potentially reducing expectations from 120 basis points to 100 or even 75 basis points.

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In their note, the traders wrote, "If the Fed cuts just 25bp, the market would not only be forced to unwind September expectations, but also the aggressive easing priced into the entirety of YE ’24 (120bps --> 100bp or 75bp)." They added that the only scenario in which a 25-basis-point cut would be seen as positive for the markets would involve a series of stronger-than-expected labor market reports in the coming month. Such data would validate the Fed's decision to limit the rate cut to 25 basis points.

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The market's current positioning suggests a delicate balance, with investor sentiment swaying between the anticipation of a more aggressive move and the risk of disappointment if the Fed opts for a more cautious approach. A half-point rate cut could reinforce the market's confidence in the Fed's commitment to addressing economic challenges head-on. Conversely, a quarter-point reduction might introduce a degree of uncertainty, compelling traders to reassess their expectations for the central bank's monetary policy trajectory.

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As the Federal Reserve prepares to announce its decision, the stock market is teetering on the edge of expectation and reality. The recent rally to record highs indicates a market increasingly hopeful for a bold move by the Fed. However, should the central bank opt for a more conservative approach, the market may face a period of recalibration, with potential implications for both short-term sentiment and long-term policy expectations. The Fed's decision will not only influence immediate market movements but also set the tone for the broader economic narrative heading into the end of the year and beyond.

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