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Last week, in a piece entitled “The Cavalry is Not Riding to the Rescue”, we asserted that it would not behoove investors to expect the sort of fiscal and monetary responses that enabled markets to swiftly recover from the Covid crisis. In this week’s comments and discussion at the Economic Club of Chicago, Federal Reserve Chair Powell confirmed that assertion.
The difference in the fiscal response remains seemingly self-evident – the current administration is actively trying to shrink the size of the federal government, not increase it further with another round of fiscal stimulus. I can’t imagine that anyone seriously considers it a possibility.
The monetary response, however, seemed to be a bit more of an open question. In recent years, we’ve become accustomed to the Fed taking measures to offset stresses in various sectors of the market. Thus, it’s understandable why investors might expect something similar when equity markets plunge. Bear in mind, however, that those interventions – rate cuts, quantitative easing, and the like – occurred either during periods of low inflation (or Covid’s deflation), broad market stresses that affected credit and banks (like the 2019 repo crisis or Silicon Valley Bank’s failure in 2022), or both. None of those are occurring right now.
Instead, the Chair went out of his way to remind us that protecting equity markets is not part of the Fed’s dual mandate. Stable prices and full employment are. I’ve often asserted that they have a third, unwritten mandate: protecting the banking system and the credit markets upon which they depend. None of those directly involve stock prices.
Powell literally responded with a chuckle when asked if the “Fed Put” might be invoked, then said “I’m going to say no with an explanation.” That explanation included his belief that markets are processing where trade policy might land, leading to uncertainty and volatility, but that they are functioning normally. Our comments last week presaged his response:
The “Fed Put” might still exist, but it won’t be exercised unless the broad economy or the banking system requires it. What we wrote in May 2022, when some investors were hoping that the Fed would rescue a falling stock market, still holds:
Here’s the real thing – the Fed has never stated that they will intervene in equity markets just because they are down. But they will almost certainly intervene if there is a crisis in credit markets that threatens the banking system or the flow of money. That is a huge difference – a crucial facet that equity investors need to understand.
The bond and stock markets are certainly under stress, but they are operating normally. QED – don’t expect a response like we saw in 2020. This is something that Powell said somewhat explicitly later in the discussion.
Despite all this, and various other comments from the Chair about not wanting to restoke inflation, expectations remain high for cuts to the Fed Funds target. On ForecastEx, we see 55% probability that the rate will not be above 3.625% after the December FOMC meeting. That implies a likelihood of at least 3 rate cuts by the end of the year. The CME FedWatch broadly agrees, with futures contracts implying 3-4 cuts by that time. How might this be possible if the Fed is at best in wait-and-see mode or even outright resistant to cutting rates? Either markets are delusional (which I highly doubt) or they are quite fearful of a slowdown that forces the FOMC to move.
Based upon my interpretation of Chair Powell’s comments, I am concerned that the market is overpricing the Fed’s willingness to move. It’s happened before. Remember the 7 rate cuts that were priced for 2024. If that is the case, we will need to determine whether traders retain too much faith in a Fed response, hope that the inflationary response to tariffs will be minimal, or whether they have a dire economic outlook in store. Hopefully it’s not the last outcome.
Related: The Volatility Cycle: How One Shock Sparks the Next