Stocks Need the Fed's Rate Cut Signal to Keep Rallying

Wall Street is anticipating that Federal Reserve Chair Jerome Powell will signal impending interest-rate cuts during the central bank’s annual symposium in Jackson Hole, Wyoming. As the discussion shifts from whether the Fed will reduce rates to the extent of those cuts, stock traders may find themselves disappointed if the expected clarity doesn't materialize.

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Eric Beiley, Executive Managing Director of Wealth Management at Steward Partners Global Advisory, emphasized the market's sensitivity to Powell's remarks. “If traders hear that cuts are on the way, stocks will respond positively,” Beiley noted. “However, if Powell doesn’t provide the confirmation the market is looking for, it could trigger a significant selloff.”

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This anticipation creates a precarious situation for money managers who have recently made substantial investments in Big Tech stocks, driving the S&P 500 Index to new heights. The market is currently pricing in a high probability that the Federal Reserve will begin lowering borrowing costs at its upcoming September meeting. However, Powell may choose to remain vague about the timing of rate cuts during his speech on Friday, a cautious and non-committal approach that is consistent with his past communications.

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“Markets are convinced that rate cuts are imminent,” Beiley added. “It would be a significant shock if Powell did not confirm this expectation.”

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Such a surprise could potentially disrupt the S&P 500's remarkable $3.3 trillion recovery, which followed a sharp selloff earlier in August triggered by global economic concerns. Since then, bullish sentiment has dominated, with the S&P 500 on a seven-day winning streak. During the week ending Wednesday, investors poured $5.5 billion into U.S. equities, according to data from EPFR Global cited by Bank of America Corp.

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However, some market experts caution that Powell may not provide the clear guidance that investors are hoping for. Tom Hainlin, National Investment Strategist at U.S. Bank Wealth Management, pointed out that Powell’s previous speeches at Jackson Hole have typically been less prescriptive, suggesting that this year’s address may follow a similar pattern.

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Bill Dudley, a Opinion columnist and former president of the New York Fed, suggested that Powell might indicate that tight monetary policy is no longer necessary. However, Dudley does not expect Powell to specify the magnitude of the first rate cut, particularly with a key jobs report due on September 6 that the Fed will consider before its next policy decision on September 18.

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Stephanie Lang, Chief Investment Officer at Homrich Berg, emphasized the importance of Powell’s tone. “If he delivers a hawkish message, the market could react negatively,” she said. “His tone will be crucial.”

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Traders are largely convinced that a rate cut is coming at the next Fed meeting, but there is uncertainty about its size. With few Fed officials scheduled to speak in the coming days, Powell's remarks carry significant weight. According to Citigroup Inc., options traders are preparing for the S&P 500 to swing by more than 1% in either direction on Friday, based on the pricing of at-the-money puts and calls.

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Despite this, there is cautious optimism on Wall Street that the worst of the market’s summer volatility is behind us. The S&P 500 is currently just 2% shy of its all-time high, and traders expect a period of relative calm ahead. Data compiled by Bloomberg show that open interest in options betting on a decline in the Cboe Volatility Index is near its highest level since June 2022, relative to contracts betting on a rise.

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Nonetheless, traders have moderated their expectations for a substantial rate cut in September, reflecting signs of a resilient economy. They are now pricing in around 30 basis points of easing, down from earlier predictions of more aggressive cuts, which are typically implemented to combat slowing economic growth, according to Hainlin of U.S. Bank.

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“We want to understand the Fed’s rate path—whether it will be a gradual cut at each meeting or if decisions will remain data-dependent, based on jobs and inflation,” Hainlin said. “However, Powell is unlikely to provide that level of detail. It’s more probable that traders will get this information at the Fed’s September meeting.”

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Historically, the Fed chair’s speech at Jackson Hole has not been a major catalyst for the stock market unless it precedes a significant shift in monetary policy, as is the case now. Since 2000, the S&P 500 has risen by an average of 0.4% in the week following the Jackson Hole gathering, according to Bloomberg Intelligence data.

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Powell’s speech at Jackson Hole in August 2022, where he warned of the need to maintain restrictive monetary policy to combat inflation, is still fresh in traders' minds. That day, stocks plunged by 3.4%, followed by an additional 3.3% drop in the subsequent week.

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This year, however, investors are hopeful that the Fed has successfully managed to engineer a soft landing, controlling inflation without causing significant economic harm. As a result, the expectation is for a dramatic policy shift in the opposite direction—a significant easing of monetary policy.

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With three policy-setting meetings remaining in 2024, traders are betting that the Fed will respond to any signs of weakness in the labor market by cutting rates as inflation continues to ease toward its 2% target. In July, underlying consumer prices fell for the fourth consecutive month, while strong retail sales data indicated that consumer spending remains robust. This combination would allow the Fed to adopt a less aggressive policy stance.

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“Powell doesn’t need to unsettle the markets,” Lang from Homrich Berg remarked. “He needs to instill confidence that inflation is under control and that the Fed is comfortable moving from restrictive to more neutral interest rates.”

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