We All Know What the Fed Will Do This Week, But What Will They Say?

There is plenty going on in the stock market this morning, as there normally is on a Monday: Macy’s (M) is reportedly being taken private by an investor group, which has caused that stock to pop close to twenty percent, and there are some interesting late earnings this week, such as Oracle (ORCL) after the bell today and Costco (COST) on Thursday. But there is one thing that is overshadowing everything else. The impact on other retail stocks of the Macy’s news and increasing evidence of strong consumer holiday spending is interesting, and the numbers from Oracle always cause a bit of a stir, but in the light of what is coming on Wednesday, it is hard to get enthused about any of that.

The FOMC, the Fed’s policy and interest rate setting committee, will meet Tuesday and Wednesday, with the latest rate announcement and outlook being released on Wednesday afternoon. Given that the whole market has been dominated by where interest rates are and where they might go for well over a year now, it isn’t all that surprising that that is at the top of everyone’s mind this morning. However, the anticipation is not based on what the committee will do. The market has priced in just about a one hundred percent chance that they will leave rates unchanged, and nobody from the FOMC has said anything over the last month to contradict that belief. So, what are we all waiting for?

A friend of mine who, like me, has around forty years of trading and market watching under his belt but who, unlike me, is still working in an institutional dealing room, put it best over the weekend when he said that traders are, right now, like naughty schoolboys waiting outside the principal’s office. They know they have done something wrong, he said, and are waiting with some trepidation to see how angry the head of school is and what sort of punishment he might dole out.

In this case “the head of school” is Fed Chair Jerome Powell, and what traders have done wrong is to make assumptions. Powell has as good as told everyone that there will be no change to rates on Wednesday, but where he and the market differ is as to what will happen in the early part of next year and why it might happen. Traders are increasingly betting on a rate cut early next year, but that cut won't be necessitated by a recession or a major economic downturn of any kind. Treasury futures are suggesting that a cut in the first half of next year is now more likely than not. Stocks are buoyant on that belief, despite the fact that the thing most likely to prompt a rate cut would be a recessionary environment, which doesn't appear to exist at this moment.

There is an assumption out there that what is logically and historically speaking the most unlikely ending to all of this, a gradual reduction in inflation without any harm being done to growth or the jobs market, is what is going to happen. I guess that reflects well on the market’s opinion of Powell’s abilities, but he is a smart man who has been in the job long enough to know that in some ways, managing expectations is the most important thing he can do. Right now, the market is pricing in perfection and anything short of that will be seen as a disappointment. Given that traders overreact to everything, that brings a risk of a massive, sudden selloff early next year if there is a sign of a slowdown or, maybe worse still, continued strength that necessitates not cutting, but even raising interest rates.

Powell would probably rather give up some gains now to avoid that, as he knows all too well that big market drops can be self-fulfilling prophecies, with the stock market dictating economic conditions rather than the other way around. If stocks collapse, individuals and businesses feel less confident about the future and cut back, even if that collapse was the result of “irrational exuberance” rather than realistic expectations for the economy and corporate profitability.

Basically, it is not that Powell sees no chance of a soft landing -- he just doesn’t want the market to assume that this is the likely outcome.

While the actual policy outcome of this week’s Fed meeting is in no doubt, traders are still awaiting the announcement on Wednesday with bated breath because they want to see how far Powell goes to tone down expectations. He could just remain neutral, or he could make it clear that any decisions are possible early next year, up to and including a resumption of rate hikes. Given the need to manage expectations, the latter possibility is more likely than most are admitting right now, and that means that caution should be the watchword for traders and investors over the next couple of days. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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