Will they or won't they? That is the question dominating the markets' attention the last two days.
The "they" in the first sentence is the Federal Reserve's Federal Open Market Committee, led by Chair Jerome Powell. The action is obviously a cut in the fed funds target rate. Powell, much like his predecessors Janet Yellen and Ben Bernanke, is fond of saying the Fed's policies are "data dependent," but I have never heard any Federal Reserve employee note the obvious truth: the stock market is Fed dependent.
The wild rally in equities in 2019 has been fueled by a radical shift in market expectations. Only six months ago market pundits were attempting to divine whether the Fed would hike rates two or three times in 2019. Fast forward to Tuesday and the markets had priced in a high probability of Fed rate cuts in 2019.
It has been an amazing transformation, and one that has produced a 1987-style rally in stock market in the first trimester of 2019.
The CME's FedWatch tool shows that the bond market has priced in a 6.7% chance of a rate cut at the next FOMC meeting, which will finish on June 19. That seems slim, but a look at the future months' futures shows just how convinced the market is that rates will be cut.
Fed funds futures indicate a 28.9% chance of a cut at the FOMC's September meeting, including a 3.2% chance of a 50 basis point cut from the current target range of 225-250 basis points.
Looking out to year-end, the futures show a 49.6% chance of a cut by the FOMC's December meeting, including an 11.1% chance of a cumulative lowering of at least 50 basis points in the target rate.
That's stunning to me. The academic argument for the Fed to cut rates based on recent data is as follows: Yes, I left that space blank intentionally.
There is simply no reason to cut rates with an economy that produced 3.2% growth in the first quarter after posting its first annual growth rate of at least 3% (including rounding) in 14 years. I just don't get it, but I know what the market wants.
And so does Powell. Unlike his predecessors, Powell's background is on Wall Street, not the halls of academia. So, he knows what traders want, and unless he is immune to any and all sources of media, he must know that President Trump is quite keen on the idea of lower short-term interest rates, as well.
So, who is really driving the bus here?
Is the Fed really independent or is Powell just a lackey for the folks at 11 Wall Street and 1600 Pennsylvania Avenue? If you are looking for the stock market for the answer to that question you need to open a new tab in your browser. The U.S. stock market is far too schizoid to yield a consistent answer in any given week, including this one.
No, the real read on the health of the economy, and the possible need for an interest rate cut, should be found in the bond market, specifically the market for U.S. Treasures. A quick glance at that market shows a still-inverted yield curve and a 2.34% yield at both the 2-year and 5-year level, which is anything but a healthy indicator for the U.S. economy.
The so-called "belly" of the yield curve is telling the Fed not to cut rates. The stock market could decline 10% and I am not sure most folks would even notice that change in their 401k balances, but if the belly of the curve moved even 10 basis points lower from its current level, it would signal an imminent recession.
So, that's the road Powell and Co. have to navigate. As two Federal Reserve board seats are currently unfilled, I have to wonder who would want the job in the first place?
The equity markets are constantly thirsty for stimulus, and the Fed's dual mandate of price stability and employment creation has been so well handled that there really isn't much for them to do.
The stock market is due for a correction, and if Jerome Powell has brought that on by injecting a much-needed dose of reality in the economic narrative, then that is a refreshing change from the "dove, dove, dove" ways of recent Fed chairs.
We'll see, but some downside hedging to your stock portfolio is a good bet until the course of interest rates in 2019 is revealed.