To The Moon

As the Federal Reserve prepares for its highly anticipated rate announcement this Wednesday, market participants are faced with a significant dilemma: will the central bank opt for a 25 basis point (bps) rate cut, or could it go further with a 50 bps reduction? Traders have been ramping up their bets on the latter, with the CME's FedWatch Tool showing a 59% probability of a 50 bps cut, up from 43% just last Friday. This marks a crucial moment for both the Fed and investors, as the rate cut may either propel the markets higher or trigger an unexpected sell-off.

The 25 bps vs. 50 bps Debate is more than just about the size of the rate cut; it’s about the underlying message the Fed conveys. If the central bank opts for a 25 bps cut, it signals a cautious yet optimistic approach, suggesting that the Fed is focused on a soft landing for the economy. This smaller rate cut could indicate that while the economy faces headwinds, it remains fundamentally stable. In such a scenario, markets would likely continue their upward momentum, buoyed by the belief that the worst of the economic uncertainty has been mitigated.

A 50 bps rate cut, on the other hand, would raise questions. Historically, deeper cuts are usually reserved for periods of significant economic stress, such as recessions. Given the recent economic data—a slowing labour market but no surge in layoffs, sticky inflation in key areas like rent, and waning market confidence—such a bold move by the Fed might signal deeper concerns about the economy. While an aggressive cut typically injects more liquidity into the system, it could also spark fears that the Fed is preparing for a sharper downturn, pushing the market into a sell-off.

Will a 25 bps Cut Continue to Boost Markets?

Historically, the stock market tends to rise when the Fed cuts rates, provided the cuts are not tied to an imminent recession. Goldman Sachs’ macro strategist points out that in six out of ten rate-cutting cycles since the mid-1980s, the stock market rallied when a recession was averted. If the Fed delivers a 25 bps cut this Wednesday, the moderate nature of the reduction could reassure investors that the economy is still on relatively stable footing, maintaining market confidence. This would likely continue to support upward momentum in stocks, particularly if subsequent economic data points—such as job growth, inflation, and GDP figures—show signs of resilience.

However, should the upcoming macro data deteriorate, even a modest rate cut may not be enough to stave off a market correction. Investor confidence would likely diminish, especially if unemployment rises or inflation fails to ease, creating a volatile environment where any gains from rate cuts could be quickly erased.

Which Assets Would Benefit Most from a Rate Cut?

Certain asset classes are poised to benefit more directly from the Fed's decision to cut rates:

1. Equities: If the Fed opts for a 25 bps cut, sectors that are sensitive to lower borrowing costs, such as technology, consumer discretionary, and real estate, could see an uptick. Lower rates reduce financing costs, making growth stocks more attractive. If the economy stabilizes, equities could continue their bullish trend.

2. Bonds: A rate cut, especially a 50 bps cut, would likely lead to falling yields in the bond market, driving up prices for existing bonds. Investors seeking safety may flock to Treasury bonds, especially if the rate cut signals deeper economic concerns.

3. Commodities: Precious metals like gold often benefit from lower interest rates as they become more attractive relative to yielding assets. If a 50 bps cut triggers recession fears, commodities like gold could see strong demand as a hedge against economic downturns.

4. Currencies: A 50 bps cut would likely weaken the U.S. dollar, as investors seek higher yields elsewhere. This could provide a boost to emerging market currencies and assets, as well as foreign stocks that benefit from a weaker dollar.

Bullish or Sell the Fact?

The final and perhaps most critical question is whether investors should be bullish or prepare to "sell the fact" after the rate cut. Typically, rate cuts are greeted with optimism, as they lower borrowing costs and inject liquidity into the financial system. However, the size of this cut will set the tone for market sentiment in the coming months.

A 25 bps cut is likely to be seen as a sign of stability, suggesting the Fed is not overly concerned about the economy’s health. This should support a bullish case, as markets respond to the increased confidence in economic growth. On the flip side, a 50 bps cut may be met with trepidation, as investors interpret the move as a preemptive strike against a looming recession. In this case, the stock market might rally briefly before investors decide to sell off amid growing fears of economic weakness.

Ultimately, the market’s reaction will hinge on the Fed’s messaging and the data that follows in the coming weeks. If the central bank reassures investors that the economy is stable, even a 50 bps cut might not cause widespread panic. But if macro data worsens, we could see a "sell the fact" scenario where short-term gains are followed by a longer-term pullback.

In conclusion, while a 25 bps rate cut appears more likely and would probably continue to fuel market gains, a 50 bps cut—though more aggressive—could shake market confidence. Investors should stay vigilant, monitoring not just the rate decision but the accompanying economic data that will shape market direction in the months to come.

@TigerWire