Why the Federal Reserve's 50 basis point rate cut didn't spark a rally

17 years to the day after the Federal Reserve's last 50 basis point interest rate cut, we have another one! It's quite the bang, to say the least, given markets were positioned for a 25 basis point cut as late as this time last week. 

"We’re not saying, ‘mission accomplished’ ... but I have to say, though, we’re encouraged by the progress that we have made," said Jerome Powell, Chair of the Federal Reserve at its post-meeting press conference held this morning.

So what tipped the balance, is it the right call, and most importantly, what happens from here on out? In this wire, I'll canvas the views of leading investors to find the answers to these exact questions.

What tipped the balance?

As I explained last week, the Fed has been laser-focused on two things: Getting inflation down to 2% and not having the unemployment rate soar. The first part has gone, for the most part, remarkably well. The Fed's preferred inflation gauge, core PCE, has declined back towards the 2% target figure in a reasonably orderly fashion (as seen in the chart below).

"We’re trying to achieve a situation where we restore price stability without the kind of painful increase in unemployment that has come sometimes with this inflation. That’s what we’re trying to do, and I think you could take today’s action as a sign of our strong commitment to achieve that goal," said Powell.

What is not going as well is the state of the overall economy and the labour market. The US jobs market has held up relatively strong on the unemployment rate figure. 

But dig deeper and you will find that more people are working at least two jobs, there are 600,000 more underemployed citizens (those who want to work more but cannot get more work) than this time last year, and there was a huge downward revision in the number of actual jobs created over the past year - minus 818,000. 

"We don't think we need to see further loosening of the labour market to get inflation down to 2%," Powell said at the press conference.

In other words, the snap data looks strong but the real economy is struggling. This data is backed up by the Fed's Beige Book which showed economic activity contracted in more of its survey areas over the last three months, as well as the run of declines in the ISM Manufacturing data which I highlighted last week. 

Was it the right call?

"Only time will tell" is the biggest cop-out but truthfully, it's also the most appropriate answer. For its part, markets didn't seem to know what to do with the information. The 50-basis point cut suggests the Fed wants to get back to its neutral rate (the "Goldilocks" interest rate which doesn't blow up inflation and the labour market) a little faster than what markets were expecting. 

"It is clear where the priorities lie; get policy back to a more neutral setting to avert the risk of recession given growing comfort that inflation is on the path to 2%," ING's economics team, led by James Knightley said. 

Rick Rieder, Chief Investment Officer of Global Fixed Income at BlackRock, concurred saying that investors were so fixated on the number (25 or 50) as if it was "Pi" where in reality:

"All that has happened is the Fed has jumped out to a faster start on the path to neural, an appropriate move given how far they are from their likely destination," Rieder wrote.

"The key takeaway from today’s move and that will resonate through the financial system for the coming months, is that the Federal Reserve will be lowering interest rates persistently for the next two years," he added.

Unfortunately for the Fed, history is not on its side. The last two times the Fed cut rates by 50 basis points, a recession started quickly after.

"The Fed lowered rates by a cumulative 100 bps from January 2001 to March 2001, and the recession started one month later. Likewise, the Fed cut rates by a cumulative 100 bps from September 2007 to December 2007, only for the Great Recession to begin in January 2008," noted Peter Berezin, Chief Global Strategist at BCA Research.

The history of the 2022-2024 cycle

Source: Federal Reserve, Note: The US interest rate is a range rather than a definitive figure as we have it in Australia.

Why the jumbo cut did not spark a rally

For its part, markets were mixed. Stocks rallied into the decision but the jumbo cut and mixed messaging saw this rally flip into a mild flurry of selling at the close. While this may be a product of the fact that investors didn't get more of what they wanted, it's also likely because all the good news was priced in.

"It’s important to note that stocks are not rocketing ahead (at least not yet) after getting what they wanted. After seven [consecutive] up days, a lot of good news was priced in," said Steve Sosnick, Chief Market Strategist at Interactive Brokers.

Bond markets, which had priced in a huge rate-cutting cycle, were left disappointed by the Fed's view there may be only another 50 basis points worth of rate cuts left in 2024 rather than the many, many cuts that were expected by traders before this meeting. That led to a rise in yields and a fall in prices, albeit from elevated levels. 

In other words, when markets get what they want, they cry out for more like it's a group of tween girls at a boyband concert. But unlike a boyband concert, the Fed cannot just conjure up an encore whenever the crowd wants one. There have already been concerns that the Fed is "behind the curve" and even Powell said himself today that had they received the July jobs report (which was a big miss against economist expectations), they would have cut interest rates already.

“The half-point cut is an admission the Fed is behind the curve, but not a sign of panic,” economist Robert Frick told Fortune magazine.

Another possible reason affects all asset classes. Powell expressed his view in the press conference that the neutral interest rate “is probably significantly higher than it was back then." Then, in this case, is a reference to the post-GFC, pre-pandemic world. All he was emphasising was that we are moving into a higher-for-longer interest rate environment. Some asset classes, arguably, still don't reflect this view.

What did go up last night? The classic investor safe havens for when things do go into a panic - Gold and the US Dollar. 

What happens now?

As you might expect, this is just the first of a series of moves that is likely coming for central banks like the Fed. Markets seem to agree that this isn't the start of a series of jumbo interest rate cuts. What's up for debate is whether there will be many cuts or relatively few. 

As Gennadiy Goldberg, Head of US Rates Strategy at TD Securities explains:

"The bar for another single 50bp rate cut seems to be high as even the most dovish Fed officials appear to be willing to accommodate an additional marginal deterioration in the labour market," Goldberg wrote to clients.

Tom Porcelli, PGIM's Chief Economist agreed, telling CNBC that "this is not the start of a series of 50 basis point cuts. The market was thinking to itself, if you go 50, another 50 has a high likelihood. But I think [Powell] dashed that idea to some extent." 

Finally, I thought I'd share one note of interest. Central banks, and in particular, the Federal Reserve, have become famous for their uniformity. 

The Fed has seen a unanimous vote for every single policy decision since 2005. That streak was broken last night when Fed Reserve Governor Michelle Bowman voted for a 25bps instead of a 50bps cut. Will Bowman turn out to be the great contrarian - or the lone lady who cried wolf? Only - say it with me - time will tell.