It was supposed to be settled by now.
The Federal Reserve is virtually certain to deliver an interest-rate cut when it concludes its policy meeting on Wednesday, but the size of that cut remains far from certain. Fed-funds futures traders have priced in a knife-edge decision between a standard cut of 25 basis points or an outsize move of 50 basis points.
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The uncertainty accompanies a debate over whether a jumbo rate cut would panic or reassure investors jittery about whether a slowing economy could suddenly slide into recession, wrecking corporate earnings and cutting the legs out from under a two-year-old bull market.
A ‘crazy’ obsession
Over the last decade or more, investors typically went into Fed meetings with a relatively clear signal on the size of any expected rate move, Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research, told MarketWatch in a phone interview. There’s decidedly less clarity this time around.
“That being said, it’s getting a little crazy…this obsession with 25 or 50 basis points,” Jones said.
Fed-funds futures traders on Friday afternoon priced in a 47% probability of a 50 basis point cut, up from 28% on Thursday. They saw a 53% probability of a 25 basis point cut. By early Monday morning, they had priced in a 57% probability of the bigger cut, with a 25 basis point move seen at 43%, according to the CME FedWatch Tool.
They have priced in 100 basis points or a full percentage point of cuts by year-end. With the Fed set to meet just three more times in 2024, including Wednesday, that implies expectations at least one of those meetings will feature a cut of 50 basis points.
The concern is that jumbo rate cuts have typically been reserved for dire circumstances, but it isn’t clear that a 50 basis point move on Wednesday would spark fears the Fed knows something that investors don’t, Jones argued. After all, a fed-funds rate now at 5.25%-5.5% with inflation running at 2.5% leaves policymakers plenty of room to begin cutting without the threat of re-igniting inflation.
“I’m in the camp that says, why wait,” Jones said. A 50 basis point cut “at least gets us to a fed-funds rate under 5%, which is still pretty tight monetary policy.”
Preview: The Fed is likely to cut interest rates until next summer as the threat of inflation fades
Awaiting guidance
More important in setting the tone for markets will be guidance from the Fed and Chair Jerome Powell on the expected size and scope of additional rate cuts following Wednesday’s decision, she said.
A half percentage point cut accompanied by a signal that further cuts will come in 25 point increments via the so-called dot plot forecast, which reflects rate expectations for individual policymakers, would provide reassurance. So would remarks by Powell reiterating that the Fed had room to front-load rate cuts because policy remains quite restrictive and inflation has dropped faster than anticipated.
In fact, it’s a standard, 25-basis point cut that would be more likely to rattle investors who fear the Fed has left rates too high for too long, said Charlie McElligott, managing director of cross-asset strategy at Nomura, in a Friday note.
With fed-funds futures traders still pricing in the strong possibility of a big move, “anything but 50bps will [disappoint] market pricing, hence acting to tighten [financial conditions] in de facto ‘hawkish’ –fashion,” he wrote.
Lurking danger
In contrast, some market veterans contend that by making a big move at the start of a monetary easing cycle, the Fed would leave investors wondering what dangers policymakers see lurking in the economy.
In the five easing cycles since 1990, when Fed rate decisions became much more transparent, the policymakers have come out of the gate with a half percentage point cut twice, observed Nicholas Colas, co-founder of DataTrek Research, in a note.
The first was in January 2001. The collapse of the dot-com bubble was amplifying a slowdown in business and consumer spending at the same time the economy was clearly skidding into a contraction. The second was in September 2007 when U.S. stocks were trading near all-time highs but strains in the housing market were heralding the onset of the worst financial crisis since the Great Depression.
Fed Chair Jerome Powell and other policymakers ”certainly know this history,” Colas said. “Their first cut will almost certainly be 25 basis points.”
They will have the flexibility to make whatever moves are necessary after that, “but will likely be wary about 50 basis point cuts unless labor market conditions rapidly deteriorate,” he said.
And in a Friday note, Kathleen Brooks, research director at brokerage XTB UK in London, offered another potentially market-negative twist on a jumbo rate cut: “A 50bp rate cut next week would be a gutsy move, however, if the Fed signal that they will front load rate cuts, then it could see fewer rate cuts down the line, which could take the market by surprise and weigh on risk sentiment.”
So, clearly there is a range of conflicting opinions around not just what the Fed is likely to do Wednesday, but how the market will react, with much also riding on how the Fed explains its decision and what it plans to do next.
Source of uncertainty
Uncertainty around the size of a rate cut lingers because recent economic data that investors had expected to settle the debate didn’t turn out to be so clear-cut.
With Powell having clearly indicated in a late-August speech in Jackson Hole, Wyoming, that the Fed’s priority is now preventing a further sharp deterioration in the labor market, many analysts had expected the August jobs report on Sept. 6 to offer an immediate answer on the size of the cut. Instead, a softer-than-expected payrolls rise accompanied by a drop in the unemployment left the report in what analysts described as a “gray zone.”
A slightly hotter-than-expected August core consumer-price index reading on Wednesday saw expectations for a half percentage point cut take a big hit. But a Wall Street Journal article on Thursday highlighting a continued dilemma among policymakers over whether to start big or small appeared to breathe new life into the jumbo rate-cut bets, analysts said.
Read: ‘Rather poor’ communication by the Fed blamed for creating doubt in the market about rate-cut path
Stock-market investors, meanwhile, shook off much of their early September gloom in the past week, aided by a sharp technology sector rebound. The Dow Jones Industrial Average DJIA posted a 2.6% weekly gain, while the S&P 500 SPX advanced 4%, trimming the U.S. large-cap benchmark’s September decline to 0.4%. The tech-heavy Nasdaq Composite COMP logged a weekly gain of 6%, cutting its month-to-date decline to 0.2%.
Stock-index futures were putting in a mixed performance early Monday morning.
Direction of travel
As for investors, the best bet may be to look past the debate over the size of the interest-rate cut and focus on the fact that a rate-cut cycle is set to get under way — a backdrop that has been both favorable and unfavorable for equities in the past depending on the state of the economy.
“The important thing is that we know the direction of travel” for interest rates, said Jones at Schwab. “It’s enough to know the direction of travel is lower to plan your investment horizon.”
