Will Fed cut rates Wednesday? Be careful what you ask for

Here’s a scenario that plenty of people on Wall Street hope happens. It’s 2:01 p.m. in Washington on Wednesday and the Federal Reserve just lowered interest rates. Question: Do stocks rally?

Before you answer yes, think for a second not about stimulus but the message policy makers would be sending about the economy. That just six months after the Fed raised rates to a relatively paltry 2.5%, things fell apart so fast that it’s necessary to send them back down.

That, in a nutshell, is the view of analysts who hope Chairman Jerome Powell’s central bank does nothing but sit on its hands this week.

“Equity investors believe that it is the obligation of the Fed to come in and save them and they’ve become conditioned for this Fed put,” said Dave Lafferty, chief market strategist at Natixis Investment Managers. “If they give the market what it wants, yeah, it will be a short-term sugar high. But I think in the long run, it undermines confidence.”

As of now, traders are pricing in a 20% chance of a cut at the Wednesday announcement. Looking further out, the implied probability of a July cut is 82%, while a September one is nearly guaranteed. That puts the Fed in a tough spot: if it gives the market what it’s clamoring for, it admits the U.S. economy is in trouble.

Another consideration for Wednesday afternoon is how much is already priced into stocks. For weeks, investors have tended to celebrate weak economic data for its role boosting rate-cut odds. Up 15% this year and 5% over the last two weeks, it’s possible equity traders have already anticipated the benefits of a rate reduction.

To wit, stocks capped their best week of 2019 after U.S. payroll additions trailed estimates. Price weakness not proving transitory? The Fed will come to the rescue. Jobless claims rising? No problem, the Fed’s seeing this, too.

A growing chorus of equity strategists are warning be careful what you wish for. Cantor Fitzgerald’s Peter Cecchini says a cut would “bode ill” for the U.S. economy. The strategist points out that late cycle Fed cuts most often precede recessions.

At Credit Suisse, Jonathan Golub warns that a scenario where an economic slowdown is coupled with declining rates poses a near-term threat to stocks. “Many investors believe that disappointing data is a positive for stocks as it gives the Fed cover to cut rates,” Golub wrote in a recent note. “Weak readings and lower yields should be a headwind regardless of Fed action.”

History shows post-cut rallies have been short-lived. UBS strategist Francois Trahan says that following a cut, short-term optimism tends to fade quickly and stocks then come under pressure again.

“We may see a pop in the market for a short time,” but stocks could still see continued pressure through the rest of the year, he wrote in a recent note.

“Just because the Fed cuts interest rates doesn’t mean that the market can’t sort of feed on itself and roll over,” Matthew Watson, a portfolio manager at James Investment Research, said in an interview at Bloomberg’s New York headquarters. “Eventually if that wears out, people lose a little bit of faith in the Fed that they can actually save the market or save the economy. I think that’s when you see a bigger washout in stocks.”