Be Careful What You Wish For: Fed Interest Rate Cuts Likely Too Late

As of Wednesday morning, markets were pricing in a 100% chance of a 25-bps Federal funds rate cut in September. This year has, in fact, been a Yo-Yo in terms of how many rate cuts are priced in by the market.

We moved from three down to zero back to at least one to two this year. Most following the Fed guidance have been mistaken, as all the Fed has done is just track what the bond and Fed fund futures tell them as they move dynamically in line with the U.S. economic data. The Fed really does not know — they stay their course of a dual mandate, follow the broader markets and then react if need be. Why fix things if nothing is broken? Or, at least, not yet.

The theme of the market all throughout the back end of last year through to now has been one of Fed cuts. It seems that every sector and stock outside of the Magnificent Seven, including other global central banks like the Bank of Japan and especially the Peoples Bank of China, have been waiting for the Fed to blink. The banks have been waiting for the curve to un-invert, waiting for their profits and their held-to-maturity assets to soar back up in value.

As the Fed cuts, it will also put less pressure on the yen and the yuan to weaken, allowing the PBOC to stimulate its domestic consumer and add liquidity if it needs to without killing its currency. But then, the bigger picture remains: Will that be even enough, given the deflationary collapse China is embarking upon?

They have continuously tried to add and stimulate since post-COVID, to see their debt move even higher and the rally fizzle out. We wait to hear what the "third plenum" in China releases for its five-year policy going forward. But one thing is certain, every single trader is waiting for the bazooka stimulus, like hungry opioid addicts, as they only know one way. But is this time different?

A cut ordinarily is meant to be a good thing if it is done in time when economic data is holding steady and inflation contained. We had the CPI last week come out much weaker on a month-on-month basis, as the slowdown is getting much more disinflationary than expected. We have often argued that Biden's massive fiscal spend masked a very weak underlying economy and market. Now that it has run its course, the true slowdown is being felt. The Fed cut is almost certain — the only uncertainty is as to the timing. Will they do so at the end of July or in September? The former may trigger a new round of inflation but the latter may be too late.

The S&P 500 Equal-Weight Index outperformed the S&P 500 by two percentage points, the most since the March 2020 crash. At the same time, the Russell 2000 index jumped 3.8% and outperformed the S&P 500 by the most since the 2008 Financial Crisis. Small caps also beat the Nasdaq 1000 index by about 6%, the largest gap since late 2020. Most eager bulls are claiming that this is the start of the broadening-out rally, whereby all the laggards of the last year outside of the Magnificent Seven start playing catch up. But sometimes, positioning is more important than fundamentals, as this has been the most consensual bet for a few years. Such sharp, extreme moves over a period of a few days are usually synonymous with risk departments at funds blowing up, not a sign of bullishness.

For now, the Fed cut has been the root cause of this move, but be careful what you wish for. If the Fed cuts because things are slowing down too much, be it inflation or employment, then it means they are probably too late. Alas, behold the recession!

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At the time of publication, Bengali had no positions in any securities mentioned.