First Fed cut in four years fools markets

After well over a decade of ultra-low interest rates, the post-pandemic hikes to over 5% came as quite a shock. We saw the US dollar strengthen significantly to reach parity with the euro for the first time in almost 20 years, while risk assets like stocks initially faltered in the high-inflation, low-certainty environment.

But after the initial understandable disorientation of multiple percentage-point increases over a period of months, US equities began, somewhat unexpectedly, to find their feet before entering a roaring bull cycle in early 2023. Indeed, from their local November 2022 lows, the S&P 500 and Nasdaq 100 are up 48% and 87%, respectively, and that's including an aggregate 5% correction over the past month.

While this kind of stock performance is unexpected in a higher-rate climate, the strong labour market and lowering of inflation brought about by the Fed's hawkish policy provided good fundamentals for growth.

Now that the Federal Reserve announced this Wednesday (18/09) that it is cutting its funds rate by a full half of a percentage point from a 5.25% to 5.50% to a 4.75% to 5.0% range in a move that caused quite the stir. But what are the reasons behind this larger-than-expected cut, and what will the reduced cost of finance mean for the stock market and the US national currency?

The first cut is the deepest

Now that the US regulator feels that inflation is under control following two consecutive months of sub-3% CPI inflation numbers, it makes sense that a rate cut would be on the cards. However, the market was somewhat taken aback by the size of the reduction. Last week, the CME's FedWatch tool predicted a 69% chance of a 25 bps, with the chances of a 50 bps one estimated at just 31%. However, it makes sense that the Fed would want to make a big impression with its first cut in four years. After all, the market has been anticipating a pivot for almost a full year, and a 25 bps cut has been priced into US stocks for a long time now.

Furthermore, given that this is not only a policy reversal as inflation reaches within touching distance of its 2% target but a response to a weakening labour market and stock market correction, the Fed needed to make a clear statement of intent without overstepping the mark. As Powell put it in his post-meeting comments: "We're trying to achieve a situation where we restore price stability without the kind of painful increase in unemployment that has come sometimes with this inflation". This means that any additional cuts will almost certainly be smaller, and we may be made to wait several months for the next. Indeed, when speaking about future moves, Powell stated that "our intention is to keep [rates] there". For stocks, this is likely to translate to modest gains and an avoidance of further corrections in a month that is typically bad for stocks.

Just a bit off the top, please

With much of the focus on equities, it's easy to lose sight of the impact of such a rate decision on the national currency. And while the Fed clearly wants to protect the dollar from the fallout of its pivot, some effect is naturally inevitable. The US Dollar Index initially traded lower following the cut's announcement on Wednesday to reach 100.21, its lowest level since July 2023. It closed the day, however, up 0.05% at 100.970. It seems that Powell's level-headed post-meeting commentary managed to temper the original jitters of a half-percentage-point cut.

Furthermore, it also seems as though the bulk of the reduction had already been priced in, with the CME's FedWatch tool indicator ultimately showing a 65% probability of a 50 bps cut by the beginning of this current week. The median policy expectations from the Fed revealed that the regulator sees interest rates at 4.4% by the end of 2024 and 3.4% by the end of 2025, which reveals a more moderate and steadier slope down to more familiar territory. The un-inversion of the yield curve on 2- and 10-year Treasury notes will also be on Powell's mind. Traditionally, this would be a positive sign that would facilitate further cuts. However, with recent evidence suggesting it could be a predictor of recession when combined with dovish central bank policy, the Fed will naturally proceed with caution to ensure its 2% GDP growth target is met. As long as unemployment is kept under control, however, it's not unreasonable to expect that the dollar will remain in and around its current level.

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