The basics of today.
Today, the Federal Reserve cut the Federal Funds Rate from 2.00%-2.25% to 1.75%-2.00%.
This was a disappointing Fed decision based on 2 easy metrics. Trump was immediately angry, but more seriously…
The Eurodollar futures contract, which is a proxy for market participants’ aggregate forecast of the future Federal Funds rate, fell. In other words, market participants had been betting on a lower future Federal Funds rate (higher Eurodollar futures price), but post-decision release and press conference, they were betting on a relatively higher future Federal Funds rate (lower Eurodollar futures price) than before.
Scott Minerd of Guggenheim Partners said on “The Fed Decides” on Bloomberg, “That which is not sustainable cannot be sustained” in reference to the difference between the dot plot and market bets for the future Federal Funds rate.
This resonated with me. As an example, market participants believe, per the Eurodollar futures market, that in December 2021 the Federal Funds rate will be about 1.5%. According to their dot plot, the Fed is currently telling us that the Federal Funds rate is expected to be 2.00%-2.25% at that time. This large gap “cannot be sustained.”
For the gap to close, at least one of the forecasting parties will be proven wrong. The question remains if market participants are betting on more rate cuts than are going to occur, if the Fed is not forecasting enough rate cuts, or if both parties are wrong. (I would take the latter)
When pressed, Powell admitted that more rate cuts may be used as appropriate.
The market (S&P 500) has had recent downturns in December, May, and July.
December was reversed by what some now call the “Powell Pivot” with change from hawkishness to dovishness speak by Powell, and May was reversed with a cacophony of Fed presidents speaking out and seemingly testing various policy ideas, which led market participants to price in a rate cut at the end of July. The most recent reversal is the most interesting because I view it as a turning point. The market began to decline heading into the July Fed meeting. This was due to the hope of a 50 basis point cut, but the result of a 25 basis point cut. The downtrend didn’t reverse on supposed dovishness and the market traded sideways through August as it attempted to qualify Trump trade-war related tweets.
At the end of August, the market began an uptrend spurred by a less anxious trade situation. This can actually be observed by the Chinese Yuan/US Dollar exchange rate. A weakening Yuan means that trade tensions are rising because traders are anticipating that China will retaliate tariffs with a devaluation of its currency. On the other hand a strengthening Yuan means that traders are anticipating that tariffs will not be increased by the US, and thus future weakening of the Yuan will not be necessary.
This can be seen in the chart below. The chart begins in April 2018, where the US-China trade war commenced. The Yuan weakened substantially thereafter. For the purposes of the point that I am making about the August reversal in stocks, you can see that beginning in September the Yuan began to strengthen due to Trump saying that he would delay the next round of tariffs. This helped finish reversing the July downtrend.
There are now 3 ways to get the market to reverse a downtrend: the Fed can introduce more dovish speak, Trump can alleviate trade war stress, or economic data can improve.
The market has reacted to back-to-back 25 basis point rate cuts as not dovish enough based on Eurodollar markets. Trade war stress appears to be trending down. Economic data is not likely to improve in the next 6-12 months. This is due to rate hikes, cuts, and their respective policy lags.
Should a downtrend resume, the Fed could stop it by cutting by 50 basis points. I am extrapolating the idea that back-to-back 25 basis point cuts were not considered satisfactory by markets. Trump could further reverse the trade war, but then he would run the risk of appearing as a loser in the trade war domestically, which he does not want with the election around the corner. As said prior, the economic data could reverse, but that seems unlikely.
If you get in the head of a bull, they are thinking that the Fed will catch us if we fall, therefore that should be priced in and we should currently rally. Unfortunately the bear knows that since that rate cut will not come until we fall… we must fall.
One last note on the move today by the Fed. The rate of interest on excess reserves was lowered by 30 basis points and the rate on overnight reverse repos was lowered by 30 basis points. This was done to address the below Repo issue, which speaks to tightening financial conditions. Beneath the surface of the market, there appears to be some ominous pressures arising. Coincidentally, the last repo blowout occurred around the December downtrend.
Another interesting recent event that many have missed was the Momentum vs. Value relocation.
The 2 largest days of the relocation chalked up a 5 sigma event. That registers a 1 in 3.5 million probability of recurrence if the initial reading was indeed by chance.
In conclusion, the Fed’s toolbox will likely not come back into play without a downtrend in stocks. Trump’s back is against the wall with attempting to “win” the trade war while maintaining a high stock market, since it is becoming more apparent that the two are mutually exclusive. With these ideas in mind, the occurrence of some ominous pressures, and the current technical make-up of the S&P 500 (approaching significant overhead resistance without an imminent new catalyst), I think it is likely that stocks run into trouble soon.
