Fed triggers US equity sell-off

l’altro ieri

Last night the Federal Reserve surprised no one when it announced a 25 basis point rate cut, taking the Fed Funds band down to 4.25-4.50%, back to levels last seen two years ago. But that wasn’t the main story. The big news came with the release of the FOMC’s quarterly Summary of Economic Projections (SEP). This showed that the majority of FOMC members now expect just 50 basis points-worth of rate cuts between now and the end of next year. While this is what the CME’s FedWatch Tool has been forecasting for a some time now, it represents a major change in the FOMC’s thinking since the last SEP from September. Back then, the forecast was for 100 basis points-worth of cuts in 2025. So this represents a significant hawkish change, and one that led to a slump in equity markets and precious metals, and a surge in the US dollar and bond yields. US stock indices registered their biggest one day declines since March 2020, while the yield on the 10-year Treasury broke above 4.50% to hit its highest level since May this year. If yields find a floor here and head higher, then they could become a big headwind for equity prices going into 2025. It’s worth considering just what a mess the Fed made of that September meeting. Not only was it far too dovish in its forecasts, once again appearing to underestimate the stickiness of inflation, but it also messed up the other side of its dual mandate, the labour side. It got completely blindsided by a couple of poor Non-Farm Payroll reports, to such an extent that it panicked and cut rates by 50 basis points rather than the 25 widely expected. That decision may have set up the central bank for yesterday’s hawkish shift, although in fairness there are several other factors, not all of them bad. Inflation has ticked up recently, which makes it harder for the Fed to justify easier monetary policy. But US growth is undoubtedly robust, while unemployment appears anchored at manageable levels. There is some uncertainty over what the incoming Trump administration may mean for the economy, but overall little has changed. The Fed can be blamed for some poor messaging, but then again investors have only heard what they wanted to hear, blocking out any negative signals. The market hasn’t suddenly woken up to a string of ‘unknown unknows’ or anything else so Rumsfeldian. Instead, the sell-off in equities looks more like a panicked response from a market priced to perfection. And while it shouldn’t be a surprise to see a bounce-back as we approach the Christmas break, the odds have certainly shortened on tops being in for all the major indices.