The market has priced in a 100% chance of the Federal Reserve reducing its benchmark rate by a minimum of 25 basis points at its meeting next week, though many are keeping their fingers crossed for a deeper cut.
Ahead of the Fed’s decision, Barclays has been preparing its clients for a range of possible outcomes and believes stocks will either experience a sharp sell-off or rally depending on the central bank’s decision.
Barclays’ chief U.S. equity strategist, Maneesh Deshpande, wrote in a note to clients that if the Fed delivers the quarter-point rate cut the market is expecting, stocks will likely show little reaction as that cut is already priced in.
However, Deshpande warned that investors need to be prepared for a surprise deeper cut or no rate cut at all.
“Based on current Fed fund futures prices, our model indicates that equity returns would be ~0% and ~1.2% for a one rate cut (our base case) and two rate cuts, respectively,” Deshpande wrote. “In the (highly unlikely, in our view) event of no rate cuts, our analysis indicates that equities would selloff by ~1%.”
The firm analyzed both regular and unscheduled FOMC meetings since 1994 to determine how much the market is likely to move if Fed officials surprise the market with their decision next week.
Investors believe there is an 80% chance the Fed will announce a quarter-point cut next week, and a 20% chance it will announce a half-point reduction.
Those in favor of a rate cut note the possible consequences of the recent data out of Europe and Asia, where economic growth is slowing and where their central banks have moved toward easier monetary policy, though more than a quarter-point rate cut could be a hard sell.
“Although you could certainly build the case for a stronger action, a 50 basis point cut, I just think it’s going to be hard to get everyone on board with that,” said Curt Long, chief economist at the National Association of Federally Insured Credit Unions. “Are we on the edge of a recession? If you are, then 50 basis points makes sense. But I don’t think the majority of the Fed feels that way.”
While the market believes there is virtually zero percent chance the central bank will hold rates steady, two regional Fed presidents have vocally advocated to leave the benchmark rate unchanged as the stock market is trading near all-time highs, second quarter economic growth is expected to come in at around 2%, and the consumer looks to be on solid footing.
“Why is [a rate cut] compelling now when the incoming data has been pretty solid and trade talks with China are restarting? I think that’s a good question,” Bill English, a 20-year Fed veteran and current professor at Yale School of Management, said. “Assuming they cut rates at this meeting, I think Jay [Powell] will have to explain what’s changed from June that made them want to take this step.”
English anticipates Powell will reiterate concerns about China, inflation, and softer investment spending which could weigh on the economy.
“Any of those three reasons may carry the day for various members of the committee,” English continued. “The communication around policy decisions will be really important… It’s an interesting time and should be an interesting meeting. Almost more interesting will be the communication around the decision. That should help explain where the committee’s coming from.”
There are also those who say the FOMC made a mistake in hiking rates last year.
“I don’t think the Fed should have ever hiked rates this cycle,” Robert Tipp, PGIM Fixed Income Chief Investment Strategist, said. “We have never had inflation exceed its target… the outcome has been inflation below target and one of the slowest recoveries.”
“I don’t think they should have hiked rates in December,” Tipp said. “The world was sending you a pretty strong signal that it wasn’t ready for higher interest rates.” The Fed funds rate is currently between 2.25% and 2.5%.
While most economists don’t see an economic contraction in the U.S. soon, the Fed’s decision next week could have big implications for the stock market going forward if the committee doesn’t announce the quarter-point reduction the market is expecting.
“Equity market reactivity increases when equity markets are rallying over the prior month,” Deshpande wrote. “Thus, historically, when the SPX has rallied by 5% over the previous month and the Fed does a surprise 25 bp cut (hike), SPX would rally (sell off) by 180 bp. Conversely, when equities are falling, effectiveness of Fed rate changes declines (e.g. during full-blown recessions).”