Stocks’ irrational rate-cut rally

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The rate-cut rally: overdoing it

It’s not all the time that we know why stock markets are rising. But, in the US at least, this is one of those times. Stocks are going up because they are pricing in, with unusual speed, the next Federal Reserve rate cut. Here is a chart of the S&P 500 since the October Fed meeting, plotted against the amount of rate cutting expected at the December meeting (as implied by futures markets):

The change in expectations has been dramatic. Since November 20, the market has gone from being quite sure there won’t be a cut next week to being nearly certain there will be. What has made the difference? To simplify: Williams, Waller and some squishy economic data. John Williams, president of the influential New York Fed, offered some dovish comments on November 21, (“I still see room for a further adjustment in the near term . . . to move the stance of policy closer to the range of neutral.”). That seemed to stop the decline in cut expectations. A few days later, Fed governor Christopher Waller (until recently a favourite in the race to be the next chair of the central bank; see below) said a weakening labour market made a rate cut sensible. Mix in a weakish retail sales report, bad consumer confidence figures, and yet another soft manufacturing survey, and the market starts writing in a rate cut with a pen.

That’s arrested the decline in the S&P 500 and sent it higher by about 5 per cent. The composition of the rally has been as suggestive as the timing. While tech, and specifically semiconductor stocks, continue to be an important contributor, rate-sensitive cyclical stocks (homebuilders, transports and chemicals) have had a great few weeks. So have quite a few beat-up consumer-facing names. Part of this, especially in housing-related stocks, may be short sellers being forced to cover. Another aspect may be the view — almost the consensus now — that the economy is set to pick up next year after a fourth-quarter slowdown. But the lower-rates narrative is undoubtedly the star of the show.

As a reason for the stock market to change course, a December cut makes little if any sense. A 25-basis-point change in short-term rates simply isn’t significant to either stocks’ discount rates or to their profit prospects. And it would be wrong to argue that a December cut is standing as a proxy for a larger change in rates’ direction of travel. The market estimate of the Fed’s destination, or “terminal rate”, has been remarkably steady at about 3 per cent for months.

Does this suggest that the rate-cut rally is on a shaky foundation? Maybe — but prognosticating about stock markets’ near future on the basis of their recent past is often a waste of time. It’s the general lesson that is important here. Investors’ obsession with the Fed is often more impactful than what the Fed does or doesn’t do, and it adds a lot of noise to the signal sent by market prices.

Kevin Hassett, Fed chair

In the Trump administration, nothing is certain until it happens. But the hints that Kevin Hassett will be the president’s nominee for Fed chair have not been subtle.

Hassett was already the likeliest candidate back in September, according to a Financial Times poll of economists. And he is not a universally popular choice. “The appointment tells you whether or not you’re going to have an independent Fed. If you have Waller, you have an independent Fed . . . Hassett is the most political choice that you can get next to appointing Don Jr . . . It’s widely perceived that he’d be very obedient to the president,” says Joseph Wang of Monetary Macro.

Wang is not alone. Last month, the Treasury sought feedback from bond traders and financial executives about Hassett, and they “told the US Treasury they are concerned . . . [that] he will cut interest rates aggressively to please President Donald Trump”, according to the FT.

Hassett has hewed to the Trump line in every word, gesture and interview for years. But his appointment by itself will not be enough to meaningfully change the path of rates or undercut faith in the Fed.

Notably, as the hints of a Hassett nomination have intensified over the past week or so, market reaction has been mild. The dollar has weakened, but that may have more to do with soft US economic data and somewhat stronger data abroad. The idea that Fed independence was under threat was already in the air. And of course, if Hassett wants a wholesale change in rate policy, he has to convince the rest of the Open Market Committee. Matthew Luzzetti of Deutsche Bank believes that

As a vocal critic of Fed policy recently, [Hassett] might find it initially challenging to convince his colleagues to bring rates meaningfully lower . . . A new chair also must move towards the centre of the Committee to forge a consensus. This could mean Hassett would have to pivot from the most aggressive calls for lower rates . . . The Chair does not have unbounded power

There is no question that the Trump administration wants to weaken the boundary between presidential will and Fed policy. The latest effort in this direction is Treasury secretary Scott Bessent’s push for residency requirements for regional bank presidents. The Fed’s independence is protected by rules and institutional structures, not individual appointees, however senior. If those hold up, the central bank will muddle through.