The Federal Open Market Committee will issue its interest rate decision and policy statement at 2 p.m. ET on Wednesday. That will be followed by a press conference with Fed Chairman, Jerome Powell.
A rate cut is not expected at this meeting, but we expect that the Fed will maintain a very dovish stance and will set the stage for a cut at the next meeting in July -- and further cuts after that. right now, three cuts are anticipated for 2019.
Market players will be looking to see if the Fed drops the word "patient' from its policy statement and will be looking for an indication that the Fed is now 'closely monitoring' the situation. Also, there will be focus on inflation and any indication that it is still below the target level.
The question we must ponder is how will the market react to the Fed?
If there is the perception of a reduction in the level of dovishness, it will likely generate a very negative response. The market has been celebrating a more-dovish Fed for a while now, and the comments yesterday by ECB President Mario Draghi make it even more likely the Fed will stay accommodative.
Gaming the reaction to the Fed provides a particularly good insight into how various market players try to gain an edge. There are dozens of different scenarios and we can never be sure which will take hold, but one way of looking at the range of outcomes is as follows:
1. First Level Thinking.
The basic market view of the Fed is that dovishness is good and hawkishness is bad. The indices will move higher on a Fed that promises lower interest rates and will react negatively to one that doesn't.
2. Second Level Thinking.
More-sophisticated market players will be looking for a market reaction that isn't quite as obvious. The best example is a "sell the news" reaction. When a news event, such as a dovish Fed, is well anticipated, the market prices in the news before it occurs. When it does occur, there is a tendency for early buyers to sell and take their profits. This causes a reversal on the "good" news. This market is expecting rate cuts within the next few months and has rallied substantially in June solely for that reason. The technical conditions for selling into a pop on this news is quite high.
3. Third Level Thinking and Beyond
These days the market action is controlled to a large degree by sophisticated computer algorithms that use logic far beyond that outlined above. The programmers anticipate the first and second level responses and seek to gain an advantage by looking for something that catches others by surprise.
One such example is to "buy the anticipated news" rather than sell it. This has happened quite often on Fed day when the outcomes have been well anticipated. Rather than sell the announcement, it is bought, which creates a short squeeze and additional fear of missing out.
The initial reaction to the Fed news will lead to longer-term strategic decisions, but in the short term, traders will be thinking along the lines outlined above.
Market bears believe that the Fed is losing its potency and won't be able to offset the problems caused by trade wars and weakening economic growth. They tell us that it is different this time -- and after a decade of an accommodative central bank, the market will start to figure out that the Fed has run out of ammunition.
The bulls point out that nothing has worked better for a very long time than to stick with the Fed. Not fighting the Fed has worked and will continue to work. When money is cheap, it has few places to go but into equities.
My game plan is to be ready to move after the news is released. I'm not going to try to anticipate a reaction but I believe that the Fed will continue to sound very dovish and that the market will react favorably. If there is a pullback I believe dip buyers will be lurking.