A Fed letdown on rate cuts could be the stock market's biggest threat now

Despite a policy pivot earlier this year and an even clearer shift just last week, the Federal Reserve remains miles apart from what Wall Street wants.

Central bank officials have indicated that a rate cut is at least on the table, but the market is demanding more — so much more, in fact, that a conflict between the current designated path of monetary policy and the amount of support that investors feel is necessary seems on a collision course.

“We’re heading for a reckoning,” said Danielle DiMartino Booth, CEO of Quill Intelligence and advisor to then-Dallas Fed President Richard Fisher. “This is where policy errors begin to happen, when the Fed cannot acknowledge they’re actually damaging the economy.”

Fed Chairman Jerome Powell, through his statements since the June 18-19 Federal Open Market Committee meeting, and his fellow central bankers via the “dot plot” of their rate expectations, at least has nodded that one rate cut could be coming if conditions continue to weaken.

In a public forum Tuesday, Powell noted that conditions have changed since an FOMC meeting in early May, and policy may have to change as well. Powell had said in May that it was unlikely the Fed would change rates.

“The risks to that outlook have increased,” he said at the Council on Foreign Relations. “We’re very mindful of those risks and are prepared to use our policy tools to support activity as needed.”

But the market is pricing in a much more aggressive policy approach.

Futures trading points to four cuts over the next year, starting with the July meeting. That’s a 100 basis point move in the overnight funds rate from the already low target range of 2.25% to 2.5%.

Should the Fed not move from the current stance, a full percentage point disappointment relative to market expectations would result in tightened financial conditions that could cost the stock market a 7% drop, according to Goldman Sachs estimates that also see a 0.8 percentage point increase in long-term bond yields, a 0.4 percentage point move higher in credit spreads and a 2% rise in the dollar. (Morgan Stanley analyst Michael Wilson thinks the stock market damage could exceed 10%.)

Since the financial crisis when the days of extreme Fed accommodation began, the two sides have been mostly on the same page. There were a few instances of divergence, such as 2013’s “taper tantrum” and former Chair Janet Yellen’s first news conference, when markets worried that the Fed was going to tighten policy more aggressively than expected. But other than that, market expectations and Fed actions have mostly managed to find common ground.

Powell’s comment in October that “we’re a long way from neutral” rattled that dynamic, and a rate hike in December didn’t help.

With the market now demanding a Fed cut, anything but acquiescence could be trouble.

“Some of the more rational people on the Fed are saying we’ve got to keep all of our options open to us even if it means disturbing the markets,” Booth said. “Therein lies the ultimate conundrum. If you disappoint market expectations at this point, given what CFOs and CEOs [are saying] and given we are headed toward a third straight quarter of negative earnings growth, then you’re in the soup.”

In addition to the fed funds markets pricing, markets are speaking loudly in a number of other ways.

Inflation expectations, which are key to Fed decision-making, have tumbled lately. The 5-year break-even rate, which measures Treasury Inflation Protected Securities against Treasurys of the same duration, fell June 17 to 1.45%, the lowest level since Oct. 4, 2016. The breakeven rate Tuesday was at 1.52%. The most recent high was 1.88% in mid-March and was at 2.15% in May 2018.

An Atlanta Fed measure of the consumer price index that features “sticky” prices that don’t move much, was at 2.4% in May, though the flexible index of prices that move more freely was at just 0.5% after falling 2.6% from April. CPI overall is at 1.8%; the Fed’s preferred measure, the personal consumption expenditures deflator, shows inflation at just 1.5%.

Manufacturing gauges are teetering near contraction territory and readings from individual Fed districts have been universally weaker.

Powell, though, stressed that Fed won’t wed itself to near-term data when meeting its mandates of full employment and price stability.

“We’re trying to set our policies so that in the medium term it is well-set to achieve those objectives,” he said Tuesday. “We’re not in the business of really trying to work with short-term movements in financial conditions. We have to look through that [and] look to the underlying economy for firm guidance.”

Markets, then, might have to exercise patience, even though that’s not always a common commodity on Wall Street.

“Sometimes you have to wait it out,” said Quincy Krosby, chief market strategist at Prudential Financial. “I don’t believe they’re going to acquiesce unless they believe the economy — forget the market — needs this.”

This weekend’s G-20 summit, and hoped-for meeting between President Donald Trump and China President Xi Jinping, could provide the kind of news that reverses the “soft” data in business surveys and removes fear over trade.

Should the economy overcome that obstacle, the markets likely would follow and reverse course on the aggressive pricing of rate cuts.

“If the economic data pick up, you’re going to see the market become a bit more cyclical,” Krosby said. “This is an important period for all of the issues the market is focused on and worried about.”