A Dovish Fed Shocks the Market, But What Happens Next?

The powerful market rally that started at the end of October mainly has been driven by optimism that inflation was under control and the Fed would start to cut interest rates early next year. Many bears were convinced that the Goldilocks economic scenario the bulls had embraced was far too optimistic. In addition, there had been a number of subtle hints from Fed members that another rate hike was possible and that interest rates likely would stay higher for longer than the market was anticipating.

That was the setup going into the announcement of the Fed's interest rate decision on Wednesday afternoon. Bears were looking for a sell-the-news reaction in anticipation of Chairman Jerome Powell repeating that the Fed was still data-dependent and was not yet ready to declare victory over inflation.

The Fed didn't follow the script and shocked the market with a prediction that there would be three 0.25% rate cuts starting early in 2024. Equities and bonds exploded higher on the news as they ignored the already substantially overbought condition of the indexes. The anticipatory bears were squeezed once again and underinvested bulls scrambled to add more long exposure.

Although the market has had a tremendous run over the last six weeks, it has not discounted this level of Fed dovishness. It was a total surprise, and now there is a tremendous struggle to reposition for an economy that looks very different than it did just a day ago.

Even with this dovish shift by the Fed, market participants are still far more dovish than the Fed. Fed fund futures are priced at nearly twice the level of interest rate cuts that were signaled by the Fed on Wednesday. The chances of a first rate cut by the Fed meeting on March 20, 2024, are put at 87%, and there is even an 18% chance of a cut as early as Jan. 31, 2024.

The odds of a rate cut are going to shift as the market contemplates how much the economy is likely to slow. Powell indicated that the main reason for the more dovish tone were signs of a slowing economy. Market bulls are still optimistic that the economy will stay strong, but the Fed's level of dovishness suggests that maybe there are deeper problems that the market is ignoring.

For now, we have extremely powerful momentum and a substantial number of market participants who are not well-positioned for the frenzy that hit. As I've written many times during this rally, strong markets stay sticky to the upside; they don't just suddenly collapse. There is a substantial number of folks anxious to buy dips, and the fear of missing out on even more gains is palpable.

The most notable aspect of the explosion of buying on the Fed news was that it was rotational. Money chased secondary and small-cap stocks that had been mostly ignored, and the Magnificent Seven and technology big-cap names lagged. Market players were looking for stocks that had lagged and were not as extended as the Nasdaq 100 favorites.

We'll see if this rotation into smaller stocks continues. Usually when big players want to add exposure quickly, they favor the Magnificent Seven names because they are big and liquid and seem to be safer. If this rally continues, those names will see plenty of inflows, but if there is a real change in market character, then look for more outperformance in the Russell 2000 and lagging groups such as biotechnology and oil.

We have a fairly quiet start on the way after Wednesday's fireworks, but the theme of the day is likely to be dip buying.