The Market Is Dangerously Dependent On The Powell Put From The Fed

Right now if the market gets bad news on the economy it goes up. Today, May 15, for example, the S&P 500 closed up 0.78% even though both U.S. and Chinese retail sales disappointed for April.

Right now if the market gets bad news on oil supplies, it goes up, as it did yesterday and today.

If it gets bad news on tariffs and trade talks between the U.S. and China it goes up–like it did on Friday, May 10, unless the news is really, really bad. And then if it has dropped on the really, really bad news like it did on Monday, May 13, it rallies the next day and the next as it has done yesterday and today.

It seems like nothing matters because all that matters is the market’s belief that the Federal Reserve is going to cut interest rates.

If retail sales are disappointingly slow, it’s good news, you see, since it means that the Federal Reserve is going to cut interest rates in 2019.

If the U.S.-China trade war ratchets up, it’s good news, you see, since it means that the Fed will be worried that higher tariffs will cut consumer spending and slow the economy, which means interest rate cuts from the Fed.

If oil prices get more volatile, it’s good news, you see, since it means that the Fed will be worried that higher oil prices might cut economic growth, which means interest rate cuts from the Fed.

Once upon a time–back after the March Fed meeting–investors and traders were convinced that the Federal Reserve would cut interest rates once in 2019. And that was enough to give the market the juice it needed to put in all time highs.

Now, though, expectations have moved from one interest rate cut in 2019 to the possibility of multiple interest rate reductions in 2019.

The CME’s Fed Watch tool, which tracks prices in the Fed Funds Futures market to calculate market expectations for a Fed move, still says that the central bank won’t cut interest rates at its June 19 meeting. The odds of a cut at that meeting, the tool says, are just 13.3%. There’s an 86.7% chance, in other words, that the Fed will leave interest rates alone.

From there, though the odds rise rapidly meeting by meeting and those rising odds have been rising extremely fast recently.

The odds for the July 31 meeting, for example, go up to 28.5% for an interest rate cut. A week ago the odds of a cut were just 14.4%.

For the September 18 meeting (the Fed doesn’t have a scheduled meeting for August) the odds of a cut rise to 53.3% A week ago those adds were just 30.2%.

For the October 30 meeting, the odds of an interest rate cut are 62.3%. A month ago they were 29.3%.

And for the December 11 meeting, the odds are 75.6% of an interest rate cut. A month ago they were 39.7%.

My rule of thumb with the Fed is that anything over 65% leads to one of two results. Either the Fed moves strongly to talk the market out of its expectations–bringing the odds back significantly below 65%–or the Fed cuts interest rates. Right now the odds for the December 11 meeting are well above that threshold. The odds for October are getting close to that level. And it wouldn’t be a huge surprise to see the odds for a September cut rise to that level with a little bit more of bad/good news on the economy or tariffs in the next week or so.

That’s a pretty amazing expectation. The Fed, which ended 2018 in a rate-raising mode–will end 2019 by cutting  interest rates in three consecutive meetings.

That’s the kind of reaction you get out of the Fed when it’s facing a global economic crisis.

And let me be very clear on this. I don’t see a looming global economic crisis. And I don’t think the Federal Reserve does either. It’s not visible in the data, no matter what data I look at. Yes, the U.S. and Chinese and global economies are slowing, but all the most recent projections show that growth rates will remain positive in 2019 and 2020. There’s no recession visible in this data. And no global economic crisis that would lead a reasonably competent Federal Reserve (I think the jury is still out on the competence of the Powell-led Fed) to cut interest rates at three consecutive meeting toward the end of 2019.

Which means that one of the biggest threats to this market and to stock prices is the growing expectation of three interest rate cuts in 2019.

A disappointment of those expectations–a discovery that the Powell Put might extend to only a single cut or at the most two–wouldn’t crash the market. Especially since it would be based on the economy remaining stronger than the worst case scenarios out of the tariff wars now say it will be.

But I think it would be enough to send stocks into a correction or an extended period of consolidation, especially if earnings growth is as weak as currently projected for the first three quarters of 2019. The consolidation would be to allow modesty growing earnings to catch up with valuations that are based on two or three interest rate cuts in 2019.

The dashing of those interest rate expectations isn’t the only danger to the current market. Another is that the financial markets will be confronted by events that aren’t in the control of the Federal Reserve. Such events could include an escalation of the trade tensions between the U.S. and China so rapid that it would outstrip the pace of Fed reactions. Another possibility would be a shooting war with Iran that actually closed the Persian Gulf to the 30% of global trade in oil that travels by that body of water. Other events such as a breakdown (whatever that now means) in Brexit wouldn’t do the trick since for an event to upset the financial markets in the days of the Powell Put it would have to be both unexpected and moving so rapidly as to leave global central banks in the dust. I suspect that a breakdown in trust in the Fed fits into the dangers too since although it wouldn’t be fast moving, it would by definition lie outside the ability of the Fed to fix.