Markets have amped up rate-cut expectations for both this year and next, with some even ludicrously calling for a 50-basis-point reduction in next month’s FOMC meeting. Inflation has trended higher the last four-five months. This makes it difficult for the Fed to singlehandedly focus on jobs.

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Risk-on is in full bloom in equities in expectation of aggressive cuts by the Federal Reserve, although investor enthusiasm is limited to the large-caps. By the end of next year, the fed funds rate is expected to reach a range of 300 basis points to 325 basis points (Chart 1). This amounts to five 25-basis-point cuts from where rates on the short end are currently. For this year, two cuts are priced in – in September (16-17) and October (28-29). If the Fed ends up cutting by 125 basis points by the end of next year, there likely will also be a change in how it views its balance sheet, which is currently at $6.6 trillion and is on its way to $4.9 trillion if the current tapering trend holds.

Rates were last cut last December, when they got reduced by 100 basis points over three FOMC meetings, including a 50-basis-point easing in September. There are calls for a cut of the same magnitude next month, but August’s jobs report will have to significantly deteriorate for this to even have a remote of a chance.

That said, Chair Jerome Powell and his team are under tremendous pressure to ease by 25 basis points next month, with fed funds futures putting the probabilities at 85 percent; already, in July (29-30), Governors Christopher Waller and Michelle Bowman dissented. Both are on the short list of candidates to succeed Powell, whose term expires next May. President Donald Trump has been demanding much lower rates.

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The Fed has a dual mandate: maximum employment and price stability. Waller and Bowman were kind of vindicated in their dissent when July’s jobs report came out. The economy only created 73,000 non-farm jobs last month, while June’s prior 147,000 was revised lower to merely 14,000 and May’s 144,000 was cut down to 19,000. August’s payrolls will be reported on the 5^th next month and will be watched closely. This covers one side of the mandate.

Inflation, on the other hand, is not giving the Fed free reins to meaningfully lower the fed funds rate. The PCE (personal consumption expenditures) index for July is due out on the 29^th. In the 12 months to June, core PCE rose 2.8 percent – a four-month high. Similarly, core CPI (consumer price index) increased 3.1 percent in July from a year ago – a five-month high. Both these metrics are substantially under their four-decade highs from 2022, but the recent trend is up; besides, they are much higher than the central bank’s two percent objective (Chart 2).

In this context, a decidedly dovish tilt in next month’s meeting is likely to elicit a negative reaction in the stock market.

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Arguably, this is already evident in small-cap stocks. These companies inherently have a larger exposure to the domestic economy versus their large-cap cousins which also have an overseas exposure. In ideal circumstances, lower rates should be favorable to these companies, not to mention the economy. But these stocks are not reflecting this.

Last week, the Russell 2000 rose 3.1 percent to 2287 but was unable to close north of 2300, with Wednesday ticking 2329 intraday. In January and February this year, the small cap index made several attempts at 2300, or just north of it, but they all failed. Subsequently, it then dropped all the way to 1733 by April 9^th. For bulls and bears alike, 2300 has proven to be an important price point going back to February 2021 (Chart 3). Unlike large-cap indices such as the S&P 500 and the Nasdaq 100, which are near all-time highs, the Russell 2000 is meaningfully lower from last November’s intraday high of 2466, which was a tad higher than the prior high of 2459 from November 2021.

The daily probably wants to go lower, toward 2200. Worse, a crucial breakout retest will occur at 2100.

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Large-caps, led by tech, on the other hand, represent a genuine risk-on.

The Nasdaq 100 printed yet another intraday high last week, with Wednesday tagging 23969, although the index finished the week much lower at 23712, up 0.4 percent versus up 1.5 percent at Wednesday’s high. As a result, a weekly spinning top developed. This follows a weekly bearish engulfing candle three weeks ago; that candle was not confirmed in the subsequent week (Chart 4).

The tech-heavy index, having bottomed at 16542 on 7 April, has come a long way and remains overbought. In the event it proceeds to unwind its daily overbought condition in the sessions ahead, nearest support lies at 22900s, with the 50-day moving average at 22744.

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For now, equity bears are likely to draw support from volatility that is itching to move higher.

It is possible volatility bulls just defended crucial support at 14.50s-14.70s on VIX. In January and February this year, the index traded there for several sessions before rallying. This was again the case on 29 and 31 July, which followed a few sub-15 readings (Chart 5). Last week, VIX ticked 14.30 on Wednesday and 14.40 on Friday before finishing up 0.4 percent to 15.09.

Right here and now, the odds of upward pressure on VIX have grown, as rate-cut hopes drove it lower enough to enter oversold territory on the daily.

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