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With this Wednesday’s FOMC decision looming, and nervous bulls eagerly hoping that the Fed will announce a dovish reversal, confirming that an easing cycle has begun or, better yet, cut rates outright (ideally by 50bps), it is unclear who has more at stake in what the Fed will reveal: stock or bond traders.
With both asset classes having gained dramatically in recent weeks in response to a sharp slowdown in economic data and rate cut odds soaring, almost 4 rate cuts over the next 12 months have been fully priced into the market.
On one hand, the bond bulls are nervous because even as the overall market is certain a dovish Powell will placate investors, analysts at Goldman (most recently over the weekend), RBC Capital Markets, TD and UBS are among those predicting that the Fed may in fact shock the market, indicating a stable Fed policy rate for the rest of this year, i.e. no cuts.
“The market has gotten pretty far out there with the prospect of building in several Fed rate cuts,” said Kathy Jones, chief fixed-income strategist at Charles Schwab, which manages about $3 trillion. “So there’s some vulnerability there. A lot will depend on the Fed’s messaging.”
Separately, Priya Misra, global head of rates strategy at TD Securities, said that “The Fed has to thread a pretty fine needle. They won’t want to box themselves into a cut before the G-20 meeting, and given they do have more time to keep monitoring the data. The Treasury market has overdone pricing in the pessimism for this year.”
Goldman tops of the trio, with the bank’s chief economist Jan Hatzius saying over the weekend that “while markets are aggressively priced for rate cuts, we believe the dovish shift indicated by Fed commentary has been more marginal in nature.”
But if bond bulls are nervous, equity investors are positively inhaling valium because even the smallest disappointment would send stocks crashing as the divergence between market expectations and the Fed’s “dots” is the widest since the dots have been published as JPM showed last week.
Meanwhile, Bank of America predicted that a hawkish Fed in conjunction with no deal at next week’s G-20 meeting – which it is safe to say is the baseline expectations – would send the S&P plunging as low as 2,650.
While this prediction may be a tad draconian, one can safely conclude that a Fed disappointment would result in the “alligator jaws” divergence between bonds and stocks (shown in the top chart) closing sharply and painfully for both bond and equity investors.
“Equity investors believe that it is the obligation of the Fed to come in and save them and they’ve become conditioned for this Fed put,” Dave Lafferty, chief market strategist at Natixis, told Bloomberg. “If they give the market what it wants, yeah, it will be a short-term sugar high. But I think in the long run, it undermines confidence.”
It’s 2:00:01pm on Wednesday and the Fed just cut rates by 25bps (or maybe 50bps). What happens next?
Will stocks soar and will bonds yield tumble more? Or – with the market already having priced in this dovish U-turn – will markets sell the news?
Let’s start with first answering the following question: what is priced in?
According to Morgan Stanley, “the expectations for a cut in July have arguably gotten extreme.” Indeed, based on fed funds futures, the market is now pricing a near 80% probability that the Fed delivers a 25 bps rate cut at their July meeting (and a near 100% probability the Fed cuts by July). As a reference, as recently as the start of last month, that same probability stood closer to 8%.
As Morgan Stanley’s US strategist, Michael Wilson writes, “given apparent decelerations across various data sets, budding signs of a demand slowdown, and political noise around trade escalation, we understand why the rates market is leaning so heavily toward a cut, but the size of the move raised a few questions for us: Just how big is the move in rates expectations for the July meeting relative to history?”
Two other related questions that emerge are how common is it to see market pricing swing so much around a single Fed meeting? Does the Fed usually deliver on expectations after such a swing?
But the biggest question that everyone wants answered is What happens to equities in the aftermath of meetings with such high hopes in cases where the Fed delivers? (and alternatively, in cases where they do not?)
Answering these questions in sequence, Wilson starts off with a bang, writing that markets have generally only repriced Fed expectations to the extent they have the July meeting within a year of or in the middle of a recession.
To reach this troubling conclusion, Morgan Stanley looked at the difference in market implied probabilities of a cut 90 vs 45 days before every Fed meeting over the last 30 years. It chose these time periods to assess change as the July meeting will be held on July 31, 44 days from today, and concluded that an additional 45-day look back would be a large enough time period to capture meaningful moves in expectations.
Here are the facts: for the July meeting, the probability of a 25 bps hike has risen about 70% in the last month (and the probability of a cut by July has risen by ~90%). For context, over similar lengths of time that saw an increased probability of a cut, the average change was ~10% and the implied T-45 day probability of a cut at that meeting was ~16%.
The bank’s screen then looked for periods of T-90 days to T-45 days before any given meeting (it called them “Focus Meetings” here) where market implied probabilities of a cut 1) had increased by at least 50% and 2) were positive (so removal of hike expectations that still left the market discounting a hike more than a cut did not count). The list of Focus Meetings using this criteria was surprisingly small and almost all meeting dates stood out as being in or relatively near a US recession.
To summarize, as the chart below shows, such drastic changes in rate cut expectations have only happened either when the economy already was in a recession or months away.
So if the bad news is that the economy is already grinding to a halt following such drastic changes in rate cut odds, the “good” news is that while it is unclear if the Fed is taking its cue from markets or vice versa, when expectations build as they have, the Fed tends to deliver. i.e., a cut – whether this week, or next month – is virtually assured.
The reason is simple: in meetings where expectations for a cut were high shortly before the cut (10 days), the Fed tended to cut. Out of the 6 analogous prior instances identified by Wilson, the Fed cut rates in all but one. The lone “exception” was August of 1989, but even there, the Fed had cut rates twice in the prior month, so one would be hard pressed to say the Fed did not also move toward meeting the market’s expectations for cuts in that scenario.
* * *
Which brings us to the key question: How do equities respond to “Focus Meeting” – such as the one in July where the market has priced in a majority probability of a cut – actions? The much anticipated answer from Wilson: “Initially, Positively, But The Impetus Does Fade.”
Without digging too deep, the market’s bullish kneejerk response is to be expected – after all;, when the market moves to expecting cuts this quickly, lack of hawkish disappointment and delivery of those cuts “tends to support upward momentum in equities.”
As shown in the chart below, returns on the day of the prior Focus Meetings through 30 days out generally tend to be positive, with 2001 the notable exception (a recession started in March of 2001).
Drilling a little bit deeper, the next chart shows the results of the same exercise for returns linked to the meetings prior to the Focus Meetings (such as the analogous to the Fed’s June meeting) and shows a similar pattern in the data. The exhibits below also shows a general trend toward positive returns.
Ok, so the kneejerk reaction to a dovish Fed is positive. Hardly a shock. But what does one observed if going out more than 30 days out post the Fed’s rate cut announcement? Here Morgan Stanley finds that the return picture is less clearly positive.
In the chart below, Wilson indexed S&P levels to 100% as of the closing price on the day before each Focus Meeting to show how the index price moved before and after the Focus Meetings. A few things stood out:
- As the Focus Meetings approached, the S&P 500 generally continued to move higher.
- A year following the Focus Meeting, there was a wide range of returns: +20% after the 1998 Focus Meeting and down ~40% following the 2008 meeting, when the economy was entering the greatest economic crisis since the Great depression.
- In cases where one year out returns remained positive, the bulk of these returns were made in the 45-day window immediately following the Focus Meetings, with returns tending to stagnate or fall off thereafter.
All this is shown below:
In other words, the Fed gives equities a temporary boost, but the momentum tends to fade or reverse. As MS adds, “This tells us the risk reward is asymmetric – a cut meets expectations and is gently supportive of equities for a time, but a failure to cut in July (in-line with our economists’ expectations) risks downside in equities and a tightening of financial conditions.”
It is also why in the 2008 financial crisis, once the fed funds rate hit zero, the Fed had no choice but to keep pushing the gas pedal, and launch QE1… then QE2, Operation Twist, QE3 and so on – a trap the Fed and other global central banks have been unable to escape a decade later.
It’s not just Morgan Stanley that warns investors to be careful what they wish for. As Cantor Fitzgerald’s Peter Cecchini warns, echoing what we have repeatedly said in 2019, a rate cut would “bode ill” for the U.S. economy, because – as noted above – late cycle Fed cuts most often precede recessions.
Over at Credit Suisse, equity strategist Jonathan Golub is similarly cautious, warning that a scenario where an economic slowdown is coupled with rate cuts poses a threat to stocks. “Many investors believe that disappointing data is a positive for stocks as it gives the Fed cover to cut rates,” Golub writes, adding that “weak readings and lower yields should be a headwind regardless of Fed action.”
In a recent note, Morgan Stanley chief global strategist Andrew Sheets was driven to the verge of a nervous breakdown by all the millennial traders who have not only never seen a bear market, but believe that bad news for the economy is good news for the market: “We strongly disagree with this “bad is good” logic”, Sheets wrote over the weekend. “The expectation that easing central bank policy can offset weaker data is at odds with both a broad swath of historical data and basic monetary theory.”
Echoing the Morgan Stanley analysis, UBS strategist Francois Trahan said that following a cut, short-term optimism tends to fade quickly and stocks then come under pressure again. “We may see a pop in the market for a short time,” but over the next 12 months stocks see continued pressure.
And although the average S&P return in the 12 months following a cut is 5.4%, “very few end close to that mark,” Trahan said, adding that variability across time ranges wildly with returns spanning from double-digit losses to gains of nearly 30%.
Joining the market skeptics, James Investment Research portfolio manager Matthew Watson told Bloomberg TV that “just because the Fed cuts interest rates doesn’t mean that the market can’t sort of feed on itself and roll over. Eventually if that wears out, people lose a little bit of faith in the Fed that they can actually save the market or save the economy. I think that’s when you see a bigger washout in stocks.”
Finally, just to make sure the explanation of this key issue is understood by everyone, even the market’s prevailing Millennial traders, Morgan Stanley explained what happens after a rate cut in baseball terms:
In the US, “bad-data-but-easier-policy” periods saw the S&P 500 post above-average returns only 38% of the time – a win rate that, if it were for a baseball team, would put it near the bottom of the current major league standings.
In conclusion, if the Fed’s rate cuts are helpless to prevent what is inevitably a lower market, what would help stocks? Simple: better economic data. This is how Andrew Sheets concluded his warning to traders:
“As strongly as we believe it’s dangerous to root for weaker conditions to bring lower interest rates, we firmly believe that markets will ultimately prefer stronger global data, even if it means that interest rates go up. This remains our view and our operating framework. And it also connects the periods where interest rate cuts were most helpful for markets, notably in 1995 and 1998, when the economy held up well as the Fed cut. Now it’s just a question of what the data bring.
Now if only strong economic data was as easy to create out of thin air as typing “Fed Funds -0.25” in the Fed computer and hitting enter..