The Fed will cut... but there's more to it than whether it's 25 or 50 basis points

The market commentary leading up to this FOMC meeting has been focussed on whether the committee cuts interest rates by 25 or 50 basis points. While on the surface it's a binary event, there's much more to it than that. The market's reaction to either call depends more importantly on the accompanying guidance and projections released with the Statement of Economic Projections(SEP).

The Fed could cut 25 or 50 basis points and the markets could be okay with either if the Fed offers guidance projections that maintain the total number of existing cuts in the curve. The critical thing is maintaining the 100 basis points of cuts priced-in before the end of the year and the nearly 10 cuts discounted before the end of 2025. For example, a 25 basis point move might prompt knee-jerk fear in the markets. However, if the Fed’s commentary and SEP make it very clear that a 50 point move is on the cards, if not likely, in either November or December, then a 25 point move at this meeting would be a relatively trivial matter of timing.?

Of course, by this logic, if the Fed sees a potential 50 point cut on the cards in one of the next two meetings, arguably it is more rational to get it over and done with now. Such a strategy would come with its own challenges. There may be the perception that it signals panic to the markets and that the Fed is playing catch up for not cutting rates in July. There's also the counter argument that the data does not support a so-called "jumbo" cut. In this scenario, the market response will depend on the finesse of Chairperson Jerome Powell's language in his press conference and ability to frame the decision. By pairing the 50 point cut with a neutral tone about the outlook and reassurance about future growth, the Fed can alleviate those fears that a "jumbo" cut is a reflection of imminent downside risks to the US economy.

The complexity surrounding this FOMC decisions doesn’t stop there, though. Complications or outright contradictions could arise from the SEP and forward guidance, especially given the fact that, in response to sticky inflation at the start of the year, the central bank lifted its dot plots in its last SEP in June. The median dot was raised from 4.6% to 5.1% for 2024, 3.9% to to 4.1% in 2025 and left unchanged at 3.1% in 2026. When looking at current market pricing, futures imply rates will end the year around 4.1% and finish 2025 in the high 2% range. Even if the Fed reverts roughly to the March projections, it still won’t fall in line with where futures are implying rates ought to head over the next two years. For Fed and market expectations to converge, it requires a massive pivot from the Fed, which will have to be backed up by downward revisions to inflation forecasts and more than likely upward revisions to the unemployment rate. That alone could stoke fear in the markets about the economic outlook.

Alternatively, the Fed could chart an entirely different course and deliver a 25 basis point cut and provide quite a neutral tone, watering down expectations of not just how many cuts could come this year, but in this cutting cycle in total. There are certainly reasonable arguments for this approach. Firstly, while Chairperson Powell and other Fed authorities have clearly guided the market to a cut at this meeting and progressive easing in policy, it hasn’t qualified what that means. A 25 basis point cut with a “let’s wait and see” message would be consistent with the central banks approach up until this point. Crucially, it would vibe with the Fed’s principle of “data dependence”, which it has relied on since the onset of the pandemic, and was a deliberate reversal of a forward looking approach to setting policy.

Hypothetically, if the Fed wants to stick with its “data dependence” principle, a 25 basis point cut and a “let’s wait and see” message would be the most reasonable outcome. Arguably, the data supports such a move. Inflation is still above target – although given its always been the Fed’s intention to lower the Fed Funds Rate to keep real yields consistent at approximately 2%, this detail isn’t likely to be weighted heavily in the Fed’s considerations. More importantly, while the labour market is obviously softening and the downgrades by the BLS to previous Non-Farm Payroll reports raise questions about whether the labour market isn’t as strong as previously thought, the US labour market is still creating jobs above the rate of participation growth. The 4.2% unemployment rate is also historically low and around the Fed’s longer run estimates. Finally, GDP keeps exceeding expectations, fiscal policy is very loose and will probably remain so no matter who wins the White House in November, consumer spending is strong, and the Atlanta GDP Nowcast for growth this quarter is a remarkable 3%.

While the principled and consistent position would be a 25 point cut and a neutral guidance, what we know about Powell’s Fed is that it is very pragmatic and will be attuned to market pricing. It will not want to risk the second order impacts on the real economy of setting off market volatility from a hawkish surprise. Given the markets are leading the Fed towards relatively aggressive policy easing, the Fed is likely to be tossing up between a 25 point cut with dovish guidance, or a 50 point cut with neutral guidance all in order to keep 100 points in the curve before the end of the year and leave open the prospect of the 150 basis points of cuts priced in for 2025. The guiding principle for the Fed this week is probably following the path of least regret. Assuming this is the central bank’s “north star”, it lends itself to the idea that the Fed will cut by 50 basis points at this meeting and counter any criticism about such a large move with the rebuttal that policy in real terms will remain technically restrictive, that it still thinks the economy is in a strong position, and that the central bank can always change course if it needs to. By doing this, the market gets the jumbo cut it is looking for and can remain positioned for another 25 point cuts in December and November. Meanwhile, the Fed can reserve optionality regarding future policy.

If the Fed executes this properly, it’s party time in the markets. The S&P 500 will smash resistance at previous record highs, with an underlying rotation trade pushing flow towards cyclicals. The US Dollar Index could drop towards or below 100. Gold prices may flirt with $US2600 and other commodities will enjoy a tailwind from the softer US Dollar. Of course, there’s downside risks at play if the Fed doesn’t cut by 50 basis points and deliver the right message. If it’s a 25 basis point move but with the desired dovish guidance to keep 100 points in the curve for this year, then there’s the high possibility of a dip and rip scenario: stocks and commodities drop and the US Dollar rallies off the back of the initial announcement, before surging in the press conference when Powell reveals is dovish plumage. The biggest move will be reserved for the unlikely outcome of a 25 point cut with a neutral tone, which will hit equities hard and set off a rally in the US Dollar

This FOMC decision is incredibly complex. Arguably by mistake and contrary to normal practice, the Fed hasn’t guided the market to its desired outcome before the meeting. As a result, there’s very elevated uncertainty about whether the central bank cuts by 25 or 50 basis points. However, it’s not a binary event, with the situation becoming more complicated by how the Fed approaches forward guidance and its Statement of Economic Projections. While the FOMC is likely to follow the path of least regret, there’s room for error and a chance the central bank prefers a different course, opening up the risk of significant volatility on an intraday basis and into the weeks ahead.

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