The market looks ahead to the Fed’s rate cut

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Two and a half years after it started raising rates, the Federal Reserve is set to cut them on Wednesday. Here’s a quick summary of how we see the market going into this announcement:

Investors are betting on 50 basis points. Markets have expected a quarter point cut for a while, but reports late last week that the Fed is mulling a half point changed the outlook. As of yesterday, 66 per cent of investors surveyed by Bloomberg expected 50 basis points. The futures market implies roughly the same odds.

The market seems to be responding not to economic news (there hasn’t been much in the past few days, other than a strongish retail sales report), but rather what they perceive to be messaging from the Fed. We will find out today whether investors have been over-reading the tea leaves.

Investors expect a soft landing. According to Bank of America’s Global Fund Manager Survey which came out yesterday, 79 per cent of fund managers are expecting a soft landing — the highest reading since May of 2023:

It makes sense that bets on “no landing”, or inflation staying higher while the economy steams ahead, have decreased, as inflation has come down towards target. It is interesting, though, that the proportion of investors who see a “hard landing” recession has not moved much — it is the same today as it was in March, May, and July.

The market has been strong recently — and tech has not been in the driver’s seat. The S&P 500 has had a decent run since the market rout in late July, despite a flinch at the beginning of this month. Yesterday it briefly hit a record intraday high. For much of August, that run was being driven by defences such as consumer staples and healthcare, and rate plays like real estate and financials. Tech stocks, which had powered the S&P for much of the past two years, seemed to be falling off. At the time, we said it might be a sign of regime change.

That’s still a possibility. While in the past week the market has been powered by tech stocks again, the general direction of travel since July has been away from tech/growth and towards defensives/rate plays/value. Here is the ratio of consumer staples returns to tech returns, and the ratio of the Russell value index to the Russell growth index:

The market can be seen as a “frightened” bull. We’re still in a bull market, and sentiment remains strong — but caution is creeping in. The American Association of Individual Investors sentiment survey peaked back in January, and while it has remained at a high level, it is working its way lower:

Citibank’s Levkovich index, a sentiment gauge which draws on the AAII data but also a variety of other indicators from short interest to gasoline prices, also remains very positive. But it has backed away from extreme “euphoria” recently:

Investors have not been piling leverage on to their trades, as one would expect if sentiment was at a fever pitch. Here is margin debt in US trading accounts (note this series only runs to July):

Part of the hesitation may be down to the fact that expectations for global growth — and in particular Chinese growth — are pretty low, even while the US charges along. This pessimism, combined with confidence that inflation is behind us, explains the deep unpopularity of commodities:

One can also see some nerves in the VVIX index, which gives an indication of expected volatility in the market. It has mostly been above its panic threshold of about 90 since the market tumble in late July, suggesting the market is expecting some major price swings:

Options investors are on the fence. The put/call ratio on the S&P 500, which can indicate how bearish or bullish investors are, has been within its typical range for the past few weeks:

On its face, that is a bit surprising given the importance of today’s meeting. “Between now and year-end ahead, the only event with a higher implied [market] move is the [US] elections,” said Vishal Vivek of Citi. “We think the probability of S&P options breaking even [today] is high” — or that increases in puts and calls on the S&P 500 today may cancel each other out, as there is not a clear consensus on which way the market will move.

Russell Rhoads of Indiana University at Bloomington added: “Investors are just not paying up for options to a point where it looks like there is an overwhelming move one way or another tomorrow.”

In sum: The bull market continues, with sentiment and prices near highs. Investors clearly have doubts about global growth, and are alert to the possibility that the US jobs market is declining outright, rather than normalising. Hence the popularity of defensive stocks. But these worries are at the periphery. There is more scope for disappointment than for positive surprises, and the Fed will have to remain on alert.

(Reiter and Armstrong)

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Homo declinis.

robert.armstrong@ft.com and aiden.reiter@ft.com.

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