Decline in Fed interest rates: 4 options and market reaction to each of them

When the US Federal Reserve plans to cut short-term rates on Wednesday, as is generally expected, it is generally accepted that already-strong equities should rise further and could continue to rise for some time.

That's what the story says, anyway. In the five other periods during the last four decades, when the Fed lowered rates without perceiving an impending slowdown, the market grew significantly 12 months later, an average increase of 16.9%, according to the statistics. from LPL Financial.

The decision to cut rates this week is a reversal from the Fed's increasingly unpopular campaign since the end of 2015, which was aimed at bringing them back to zero, where they resided since the 2008-09 financial crisis. . Analysts on Wednesday called for a reduction in "insurance" against US expansion, including the trade war between the United States and China and the economic slowdown in Europe.

In the future, how the Central Bank's Federal Open Market Committee deals with investor psychology will determine what actions do. After 10 years of low rates, the market likes them a lot and more than ever. For this reason, the reaction of the stock market to future FOMC actions could range from sales to indifference to euphoria, depending on the timing and extent of policy action taken by the policy group. from the Fed.

GCE's futures contracts with the Fed indicate the market is expecting a quarter point cut on Wednesday from its key policy rate of federal funds, which calls for an agreement for other short-term rates term. And the CME barometer predicts that, by the end of the year, two further declines of this type, for a total for 2019 lower by 0.75 point than today 's . At present, the benchmark is targeted between 2.25% and 2.5%.

Corporate profits (which have risen sharply but are expected to grow) and the current health of the US economy (3.7% unemployment rate, one of the lowest in half a century ) are important factors that influence the upward trend of the market. Interest rates, however, are the predominant force because they affect the cost of borrowing for every consumer and every business.

Here's how the market could react to the Fed's four most likely options.

Do nothing

The chances of this happening are equivalent to a killer comet hitting the ground this summer. CME futures do not provide a chance in the future. Fed Chairman Jerome Powell and other Central Bank figures telegraphed for weeks that they would lower rates at their July meeting. And Powell is known for his style of deliberation, step by step, so that a sudden change would be a way out of the character.

Nevertheless, the Fed, under another leadership, has already delivered surprises. Perhaps Powell, who likes to say that the Fed's policy is "data-dependent," suddenly gained new information that inflation is about to become widespread and so decides that a reduction would be a folly .

That said, doing nothing would undermine the credibility of the Fed. When everyone is ready for a cup, staying on the spot would invite the market to fall. "The shares will sell a lot," said Bill Zox, director of fixed income investments at DiamondHill Capital Management.

Investors tasted this inconvenience in December, after a further quarter-point rise, when Powell insisted that Fed policy – at the time, further raising rates interest and narrowing his $ 4 trillion bond treasure – would remain unchanged. The Dow Jones IndustrialAverage lost 300 points, and Powell quickly switched to a more dovish position.

A quarter point cut

In other words, one and it's done. If that were his intention, Powell could point it out at his press conference on Wednesday, it might come after the FOMC minutes are published or the Fed officials could reveal it in public appearances.

According to Wall Street strategists, it is highly likely that equities would continue to rise after the announcement of the quarter point cut, but once the strategy of "one and done" will have been revealed, the rally would be amortized or could even disappear. "Investors will want more," said Jason Brady, CEO of Thornburg Investment Management. And if they do not get that result, pay attention. The CME probabilities for one and made this year are only 9.6%.

Although some Fed officials have advocated limiting the FOMC's action to a quarter-point drop, the Fed's institutional leanings are a multi-pronged move. Only once in recent times has the Fed opted for a one-sided reduction in 1997. Given Powell's penchant for progressivism – imposing piecemeal policy changes in a series of small bites – a reduction in the amount of money spent on the market. a quarter point Wednesday would probably not be the end of the easing policy.

Cut half a point

This would be a bold step, generally considered an economic storm cloud. Last time, the Fed used cuts of half a point on the frightening days of 2007 and 2008 as it approached zero.

Nevertheless, a half-point move would show that the Fed is seriously considering monetary easing. "The market would love that," said Scott Colyer, managing director of Advisors Asset Management. For the moment, CME futures are strongly oriented towards a quarter-point movement Wednesday: 78.6%, against 21.4% for half a point. Thus, a drop of half a point would be a positive surprise and would undoubtedly contribute more to the stock market.

Gradual reduction of rates

While the CME predicts that a total reduction of three out of three points is the most likely outcome in December, stock investors would certainly feel comfortable if this came to fruition. This could take any combination: three separate cuts of a quarter point or half a point followed by a quarter point drop. As the market expects, stocks should react positively throughout the year.

One caveat: There is a school of thought that anything that could be less than a total reduction of three out of four points could scare investors, indicating that something is wrong. Such a conclusion could temper market gains.

At that time, Diamond Hill's Zox said, "you are crossing the line, and it looks like the Fed is preparing for a recession." surgery. As a result, the market may run out of steam.

This week could be a point of inflection for the market, with respect to interest rates, with crucial developments to come. Craig Birk, CIO of Personal Capital Advisors, said after Wednesday, "The following is what is really important."

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