Why Wall Street May Not Want a Big Federal Reserve Interest Rate Cut
Key Takeaways:
– The Federal Reserve is expected to cut its benchmark interest rate for the first time in four years.
– Recent inflation data has made Wall Street more confident that the rate cut will be more modest than previously anticipated.
– A large rate cut is usually seen as a sign of financial distress, which is not a good omen for Wall Street.
Wall Street has been eagerly anticipating the Federal Reserve’s decision on its benchmark interest rate at its upcoming policy meeting. However, a bigger-than-expected rate cut may not be the welcome surprise that many investors are hoping for.
For weeks, there has been a debate in the markets about whether the Fed will cut its rate by a modest 25 basis points (bps) or slash it by 50 bps. Recent data suggesting that inflation is not yet under control has settled the debate. Core inflation, which excludes volatile food and energy prices, rose 0.3% in August, slightly above expectations. This increase, driven mainly by rising housing costs, has raised concerns about the risk of reigniting inflation if aggressive rate cuts are implemented.
As a result, market expectations for a 50 bps cut have fallen to below 15%, according to CME Group’s FedWatch tool. Although those odds have rebounded to 28% by Thursday, they remain significantly lower than they were just weeks ago. This shift in market pricing makes it increasingly difficult for the Fed to justify a large rate cut without triggering a significant market surprise.
The reasons behind a rate cut matter to Wall Street. While lower interest rates are generally positive for equities, the market wants to understand the rationale behind the rate cuts. If the Fed is cutting rates due to concerns about the labor market, it suggests that the economy is slowing at a faster pace. This may not be the outcome that investors are hoping for.
Fed officials have assured investors that they will act if the labor market continues to show signs of distress. Recent data has indicated a cooling labor market, but it hasn’t confirmed investors’ worst fears. The market is still expecting the Fed to cut rates by a full percentage point before the end of the year, which implies at least one 50 bps cut in the remaining scheduled policy committee meetings.
However, a 50 bps cut is rare outside of economic crises. The last two times the Fed implemented such a large cut were in response to the Covid-19 pandemic in March 2020 and the 2008 Global Financial Crisis. Outside of these crises, the Fed hasn’t made a 50 bps cut since November 2002. Therefore, it would likely take a significant deterioration in the labor market to prompt such a move.
Deutsche Bank analysts estimate that conditions that could trigger a large rate cut include payroll gains slowing below 100k, a sharper rise in the unemployment rate, or evidence of increasing layoffs. However, it’s unclear what individual FOMC members would consider a significant deterioration, or whether a unanimous vote among committee members would be required for such a cut.
In conclusion, Wall Street may not welcome a big rate cut from the Federal Reserve. Recent inflation data has raised concerns about the risk of reigniting inflation, making a more modest rate cut more likely. The reasons behind rate cuts matter to investors, and a large cut could suggest a faster slowdown in the economy. While the market still expects further rate cuts, a 50 bps cut may not be the outcome that Wall Street desires.
