Conjoined Twins: Bull Market and a Dovish Federal Reserve
Conjoined Twins: Bull Market and a Dovish Federal Reserve
The overwhelming consensus is that the Federal Open Market Committee meeting on July 30-31 will reduce the Fed funds rate. A Reuters poll shows 95% of economists are anticipating that and the CME futures market implies 100% probability of at least a 25 basis points reduction to 2-2.25%. So what happens next?
My colleague Tom Lee wrote last week that a market "blast off" occurs when the Fed cuts and US isn’t in recession. Well folks, it seems pretty unlikely we're in the midst of a recession. And the average return of the S&P 500 index over the six months following one of those non-recessionary cuts is 13.5% and 16.5% over 12 months.
Assuming a cut happens, next year or so could be a very good time indeed for the equities markets, if history is any guide. The US economy seems healthy enough—second quarter gross domestic product growth was 2.1% on an annual basis, according to figures released Friday—and consumer metrics are in good shape. Lending is up, retails sales reached record highs in June, as did spending on motor vehicles and parts dealers.
Of course, this begs the questions why a cut is necessary. John Williams, vice chairman of the Fed's rate-setting committee and head of the regional Fed bank in New York, said last week that "When you have only so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress….you don't have to wait until data turns decisively if you can afford to."
In other words, with rates already so low, the Fed would rather cut too soon by anticipating economic weakness than cut rates in response to existing economic weakness where bigger, frequent cuts are necessary but not possible. That implies the Fed is capable of anticipating economic conditions accurately and successfully “manage” a $21 trillion economy. Let's be honest, economists are horrific forecasters.
Three of the biggest risks to the U.S. economy are US-China tariffs, slower global growth, and other unexpected geopolitical tensions like Middle East tension. But guess what the other big risk is? Fed policy. We saw last December (S&P 500 down 8% following a Fed hike) how much trouble Fed policy errors can bring to the market. That was the worst ever sell off in equities following a FOMC meeting. Afterward, the Fed pivoted to its now dovish stance. For now this bull market seems to need a dovish Fed, but the Fed needs this bull market. With these two joined at the hip, another market "fight" could get ugly.
The 10-year Treasury note yield is around 2.08 versus 2.05% the Friday before. As noted, CME Fed futures, a pretty accurate indicator of where rates are going, continues to place a 100% probability of at least one cut at the next FOMC meeting and another one in September.
Upcoming: 7/30-31 - FOMC meeting.
