Fed's Rate Cut: 4 Options and How the Market Will React to Each

When the Federal Reserve moves to cut short-term rates on Wednesday, as is widely expected, the conventional wisdom is that already-buoyant stocks should head higher and may well keep climbing for a while.

That’s what history says, anyway. In the five other such times over the past four decades that the Fed trimmed rates without an imminent downturn visible, the market was a lot higher 12 months later, up an average 16.9%, according to LPL Financial statistics.

A decision to lop rates this week is a reversal from the Fed’s increasingly unpopular campaign since late 2015 to lift them from almost zero, where they had resided since the 2008-09 financial crisis. Analysts are calling a cut on Wednesday “insurance” against America’s expansion getting wrecked by things like the U.S.-China trade war and an economic slowdown in Europe.

Up ahead, how the central bank’s Federal Open Market Committee handles investor psychology will determine what stocks do. After 10 years of low rates, the market likes them a lot, and more than ever. That’s why the stock market’s reaction to the FOMC’s upcoming actions could range from a sell-off to indifference to euphoria, depending on the timing and extent of the moves the Fed’s policymaking panel makes.

The CME’s Fed futures contracts indicate that market sentiment expects a quarter-point drop Wednesday in its benchmark federal funds rate, which calls the tune for other short-term rates. And the CME barometer anticipates that, by year-end, two more such decreases, for a 2019 total of 0.75 point lower than today. Right now, the benchmark is targeted between 2.25% and 2.5%.

Corporate earnings (which have been growing robustly, although are forecasted to ebb) and the U.S. economy’s current health (unemployment at 3.7%, one of the lowest levels in a half-century) are strong factors influencing the market’s upward direction. Interest rates, though, are the predominant force, as they affect the cost of every consumer’s and every company’s borrowing.

Here’s how the market might react to the Fed’s four most likely options.

Doing nothing

The odds of this happening are the equivalent of a killer comet striking the earth this summer. CME futures give a stand-pat outcome no chance. Fed Chairman Jerome Powell and other central bank figures have telegraphed for weeks that they will decrease rates at their July meeting. And Powell is known for his deliberative, step-by-step style, so a sudden shift would be way out of character.

Still, the Fed under other leadership has delivered surprises before. Maybe Powell, who likes to say that the Fed’s policy is “data dependent,” has suddenly acquired a new piece of information that shows inflation is about to run rampant, and therefore decides that a cut would be folly.

That said, doing nothing would be a body blow to the Fed’s credibility. With everyone primed for a cut, staying put would invite a market tumble. “Stocks will sell off a lot,” said Bill Zox, chief investment officer for fixed income at Diamond Hill Capital Management.

Investors got a taste of such unpleasantness in December, after another quarter-point increase, when Powell insisted that Fed policy—at the time, meaning more rate boosts and shrinking its $4 trillion bond trove—would remain unchanged. The Dow Jones Industrial Average sank 300 points, and Powell soon pivoted toward a more dovish stance.

One quarter-point cut

In other words, one and done. If that’s the intention, Powell could indicate it in his news conference Wednesday, it could emerge once the FOMC’s minutes are released or Fed officials eventually could reveal it in public appearances.

Most likely, Wall Street strategists say, stocks would keep on rising after news of the quarter-point reduction, but once the one-and-done strategy is revealed, the rally would become muted or may even peter out. “Investors will want more,” said Jason Brady, CEO of Thornburg Investment Management. And if they don’t get that result, watch out. The CME odds for one and done this year are just 9.6%.

Although some Fed officials favor restricting FOMC action to a mere quarter-point drop, the institutional bent of the Fed is for a multi-part movement. Just once in recent times has the Fed gone for a one-and-done cut, in 1997. Given Powell’s penchant for incrementalism—imposing policy changes piecemeal in a series of small bites—a quarter-point cut on Wednesday likely would not be the end of the policy easing.

Cutting a half-point

This would be a bold step, one typically taken as economic storm clouds gathered. The Fed last resorted to half-point reductions in the frightening days of 2007 and 2008, in its march toward near-zero.

Still, a half-point move would show that the Fed is serious about monetary easing. “The market would love it,” said Scott Colyer, chief executive officer of Advisors Asset Management. At the moment, CME futures are tilted heavily toward a quarter-point move on Wednesday: by 78.6%, versus 21.4% for a half-point. Thus a half-point drop would be a positive surprise, and would probably juice the stock market the most.

Gradually dropping rates

With the CME predicting that a total three-quarter-point reduction is the most probable outcome by December, stock investors surely would feel comfortable if it came to pass. This could come in any combination—three separate quarter-point cuts, or a half-point followed by a quarter-point drop. As the market expects this, stocks should respond positively through the year.

One caveat: A school of thought exists that anything more than a total three-quarter point reduction could risk spooking investors, signaling to them that something is wrong. Such a conclusion could temper any market gains.

At the that point, argued Diamond Hill’s Zox, “you cross the dividing line, and it looks like the Fed is preparing for a recession.” Then, he said, the Fed’s easing would no longer be perceived as just insurance, and more like emergency surgery. The market could wilt as a result.

This week could well be an inflection point for the market, vis-à-vis interest rates, with crucial developments yet to unfold. After Wednesday, said Craig Birk, CIO at Personal Capital Advisors, “What comes next is what’s really important.”