50 Basis Point Rate Cut - Big Decline In Small Caps, Large Caps Fall Slightly

Before getting into the possibility of an upcoming 50 Basis Point Rate Cut, let's review the current market. S&P 500 fell slightly for the 2nd straight time on Monday as it was down 0.17%. The market is cautiously waiting for the G-20 summit. But investors were cautiously waiting for the Fed meeting last week, stocks started rallying sharply ahead of the meeting. 

We can’t expect the market to be quiet because there will be news reports on the trade talks every day. At any moment President Trump can tweet that the talks are going well and a deal is close. We’ve seen positive trade related comments from the administration cause stocks to increase all year. Even though those comments this winter and spring were clearly wrong as there still isn’t a deal.

Nasdaq fell 0.32% on Monday. It will crater if there’s no trade deal. It is a tech-heavy index and tech stocks are affected the most by tariffs. Russell 2000 fell 1.26%. It has underperformed the S&P 500 for the past couple of quarters. That’s even with the dollar index relatively high and interest rates very low. 

VIX fell 0.91% to 15.26. This was another day where the market and VIX were positively correlated. CNN fear and greed index is at 50 as it fell 2 points. If the market craters in the next few weeks, it won’t be because sentiment was euphoric.

Worst sectors on Monday were energy and consumer discretionary. They fell 0.93% and 0.51%. Oil actually increased 0.8% to $57.90. Investors probably are getting more pessimistic on the demand side. 

If the geopolitical tensions are rectified, oil could collapse at least 5% very quickly. Best 2 sectors were materials and consumer staples as they increased 0.45% and 0.27%.

50 Basis Point Rate Cut - Fed Definitely To Cut Rates In July

In keeping with the theme that investors became less enthused about economic growth prospects, both the 10-year yield and the 2-year yield fell 4 basis points. Latest 10-year bond yield is 2.01% and the latest 2-year bond yield is 1.73%. 2-year yield falling means the odds of multiple rate cuts this year increased. 

There is still a 100% chance of a rate cut by July. Odds of that one cut being 50 basis points increased to 41.6% from 28.1%. So much for the Fed being fearful of getting too close to the zero bound without a recession. There is also a 70.3% chance the Fed cuts rates at least 3 times this year. If the Fed cuts rates by 50 basis points in July, suddenly those 3 rate cuts this year don’t sound like a lot.

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As you can see from the chart above, the closer we get to a Fed rate decision, the more accurate the Fed funds futures market becomes. 

My rule of thumb is if the futures market sees at least a 70% chance of an action, that action will most certainly occur. In the chart, once the market prices something in 31 days before the meeting, there is a 75% chance that will occur. This is based on the data from all decisions since 1994. Fed has been reacting to what the market wants since Greenspan was Fed chair in the 1990s. 

The Fed’s next meeting is on July 31st, so if rate cuts are expected on the 1st, they are very likely to occur. Only thing preventing cuts would be a trade deal announcement. Economic data will either push the market towards one or two cuts. If the regional Fed data accurately portrays a decline in the ISM manufacturing PMI, two rate cuts are likely.

Big Improvement In Chicago Activity Index

May Chicago Fed national activity index was still negative. But it improved greatly from April. April reading was revised down 3 basis points to -0.48. That's quite close to being recessionary which is -0.7 or below. May reading showed sharp improvement. It was -0.05 which beat estimates for -0.18 and the high end of the consensus range which was -0.15. 

May reading was helped by utilities and motor vehicle production. They added 40 basis points to the index after subtracting that much in April.

This index was pushed negative in May by the employment component which hurt it by 6 basis points after helping it by 5 basis points. Personal consumption and housing, as well as sales/orders/inventories, didn’t move much. This overall reading was the best since March when it was positive 2 basis points. 

Relatively volatile month to month data explains why we look at the 3-month moving average. That increased from -0.37 to -0.17 in May. That’s the best moving average since January. To be clear, the moving average bottomed at -0.42 in April 2016.  

Weak Citi Surprise Index

It’s good to see a strong national activity index because there hasn’t been much solid data lately. I think sentiment is hurt the most by the trade war because of the uncertainty it brings. The fact that most economic data has been week isn’t in our imaginations. 

As you can see from the chart below, the Citi surprise index has been declining deeper into the negatives in the past couple of months. It’s obvious the economy is in a slowdown. If economists know the economy is slowing and reports are missing their manageable estimates, it’s a bad sign.

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50 Basis Point Rate Cut - Conclusion

It’s possible the stock market is waiting for the G-20 summit before making any movements, but don’t fall asleep on the market because it rallied into the Fed meeting. 

Plus, President Trump can tweet about trade at any moment. After we get through the trade news, the market’s focus will be on the July Fed meeting and the upcoming earnings season. 

Obviously, trade will still be in the news until there is a deal though. I predict a trade deal will get done this year. We will learn a lot about the negotiations in the next 5 days.