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The market owns the Fed, and that's why it's cutting rates

Joe Fahmy
Contributor

The upcoming Federal Reserve decision on July 31 is important because it will likely signal a shift in the Fed’s policy on interest rates and possibly the beginning of a new easing cycle. The main two questions market participants are focused on are: 1) What are the possible scenarios to expect from this Fed meeting? 2) Why is the Fed cutting rates in the first place?

The Fed speaks, and the market reacts

Before I get into the scenarios, let’s review the recent history because many people underestimate how much influence the Fed has on the stock market. For example, the main reason for the decline in Q4 2018 was when Fed Chair Jerome Powell said in early October he would raise rates three or four times over the next year. The market’s strength since early January was a result of Powell reversing course and saying he would be “patient” in raising rates. The decline we saw in May was after the Fed’s May 1 meeting when Powell did not give the markets what it wanted — which was to hint at a rate cut. Finally, the resumed strength we’ve seen since June was due to Powell hinting at an upcoming rate cut.

In their July 31 meeting, the likely scenario is for the Fed to cut rates by ¼ point. The most important part will be the Fed’s statement and Powell’s press conference after the decision. If he hints at more cuts over the next year, the market will embrace it and we will likely continue higher. If the Fed signals a “wait and see” stance with the possibility that this is a “one and done” rate cut, the markets will decline over the near-term because Fed funds futures are pricing in a few more cuts over the next year. If the market drops because it doesn’t get what it wants, the funny thing is it will eventually stop sliding when the Fed comes out and reverses their course again because that is the accommodative world we’ve lived in over the past several years.

The two possible scenarios we’ll see this week

Two other scenarios this week would be a ½ point cut or no cut, both of which are unlikely. A ½ point cut would of course be welcome by the markets but again, the statement afterwards will affect the direction over the near-term. No cut would shock the markets and probably lead to a 5%-10% decline. Again, we would only decline until market participants and politicians cry enough about it, thus leading the Fed to eventually cut. In other words, the market clearly owns the Fed and one would be foolish to think otherwise.

The expected rate cut has led to a heated discussion among economists and market participants. Many are confused about WHY the Fed is cutting rates when we supposedly have a strong economy and the markets are near all-time highs. My first response is the old saying “Don’t fight the Fed!” Stop being a macro economist and accept that we are likely moving back to an easing cycle. In other words, I prefer to take advantage of this accommodative environment because arguing with the Fed is futile.

It’s possible they are doing this because many countries are already in a recession. Some may argue that it’s not the Fed’s responsibility to worry about other countries but we are no longer an isolated economy. Close to 50% of the revenues of S&P 500 companies come from overseas. Other factors such as Brexit and the China trade wars continue to weigh on many parts of the world. As you can see in the table below, only 15 of 41 countries see PMI above 50, the lowest since July 2012. PMI is the Purchasing Managers Index and is an indicator of the economic health of the manufacturing sector.

Also, the central banks around the world have become more coordinated over the years. The chart below shows that for the first time since 2013, not a single central bank is hiking rates. Basically, you have the U.S. expected to cut rates this week, the European Central Bank (ECB) signaling that action is likely in September, and China has resumed their easing policy. So when they say “Don’t fight the Fed,” good luck fighting all the globally coordinated Feds!

Chart courtesy of Joe Fahmy

Part of the reason sentiment is so muted with the markets near all-time highs is that so many people are frustrated with the Fed. Again, it is a waste of time over-thinking things and fighting this. We have seen very little distribution (professional selling) from the big institutions and the market’s leading stocks continue to act well both technically and fundamentally. We are going back to being in a globally coordinated effort to keep interest rates low and the markets high. Don’t fight it!

Read more:

Why the market will head higher into year end

The single biggest reason markets dropped so hard last year — interest rates

“Blew it!” Here’s everything Trump has tweeted about the Fed

I can be reached at: jfahmy@zorcapital.com

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