I Can’t Fight This Feeling

(I’m not linking the song that shares this title. I’ve never liked REO Speedwagon)

Yesterday’s piece, comparing the 25 vs. 50-basis point question facing the Federal Reserve to the “will they / won’t they” decision in a formulaic romantic comedy, must have put an ‘80’s power ballad into my head.  Regardless of the source, I have been forced to reckon with the nagging suspicion that tomorrow’s FOMC meeting has the potential to be a major “sell the news” event.

As I type this, the markets have not fully coalesced around a consensus outcome for the rate decision.  The CME FedWatch currently shows a 60/40 split in favor of the larger cut, though that is down from 70/30 yesterday and earlier today.  Meanwhile, the IBKR ForecastTrader shows a 72% chance that the rate will be set above 4.875% tomorrow.  Normally there is sufficient guidance from the talking heads at the Fed that those probabilities approach 90-100% for a given outcome.  Thus, we go into this FOMC meeting with far less clarity than is typical.

Over the past few days, I’ve been laying out my case for why I favor 25bp over 50bp.  Yesterday I offered four reasons, noting:

1. We saw price pressures in the Payrolls and CPI reports,
2. The Fed doesn’t like to surprise markets
3. Political considerations ahead of an election
4. The very reasonable change that the Summary of Economic Projections shows an economic forecast at odds with investor expectations and/or rate cut projections are more modest.

Furthermore, a week ago, when expectations strongly favored a 25bp cut,  I offered the following extra considerations:

• As for the “monetary policy is too restrictive” argument, my retort is “based upon what?”  A stock market that is in spitting distance of all-time highs?  A corporate bond market that absorbed $80bn in new issuance in three days this week without blinking?  We’ve all become liquidity addicts, hoping desperately for a fresh dose whether we really need it or not.
• Someone asked me … if the soft-landing narrative is in peril.  I’m not sure why (especially given the paucity of precedents for them).  The AtlantaFed GDPNow model projects 2.1% GDP growth [it’s now 2.5% as of today].  That is indeed consistent with a soft landing.  An unemployment rate of 4.2% is something historically enviable, though it is indeed above its lows.  And if we should doubt a soft landing, how can we expect double-digit earnings growth for the S&P 500 next year?

As I read through these this morning, I still believe that the Fed should still lean to 25bp.  But years of trading experience has taught me to respect the message of the market, and that message has been saying 50bp.  A long-time market watcher reminded me this morning that it is unlikely that the Wall Street Journal’s Fed whisperer would have penned a story that left the door open to 50bp – during a quiet period, mind you – that didn’t reflect the message that the central bank wanted to portray.

Yet that’s where the problems may come in.

Of course there will be widespread disappointment if the Fed opts for 25bp.  Equity markets always crave more liquidity, and at the same time, bond markets have all but priced in an aggressive rate cutting path for future meetings.   The smaller cut would bias against both.

But what if we get 50bp?  Much depends upon the messaging. 

• If it’s 50bp and a clear statement from either the FOMC and Chair Powell that the economy is fine but they are embarking on a path to quickly normalize restrictive short-term rates, then markets should do OK.  But again, is monetary truly restricting investment activity?  It is quite possible that they indicate that a larger cut might be all about getting the ball rolling but hedge on the necessity of future cuts.  Remember that rates are quite high by the standards of the period since the Global Financial Crisis, but that both nominal and real rates are relatively normal over a longer historical scope.
• But if it’s 50bp because the Fed tells a dire picture about the economy, or alternatively, is so sanguine about the economy that they have little interest in cutting rates at the pace implied by markets (5 cuts in 2024 and another 5 in 2025), then that would be a negative regardless.

Finally, assuming we close at the levels we see at midday, it would be seventh straight up day for the S&P 500 (SPX).  That is a long streak and implies that a significant amount of good news has been priced into equities.  The Fed will need to deliver even more good news to keep exuberant equity traders happy.