The Federal Reserve next week is set to answer the market’s burning question about the size of its first interest rate cut in four years, and Interactive Brokers’ senior economist said stock bulls should be rooting for a standard reduction of 25 basis points.
On Friday, odds of a large cut of 50 basis points jumped to nearly 50% after The Wall Street Journal reported that monetary policymakers were still deciding which way to move at their meeting that ends Wednesday. Stocks (SP500)(COMP:IND)(DJI) finished the week higher, with the S&P 500 (SP500) rising 4%, its best week so far this year.
“If the Fed does a 50 [bp cut] next week, we will likely see a dramatic bull steepening of the yield curve alongside a bullish yen,” José Torres, senior economist at Interactive Brokers, said in a note Friday. Federal Reserve Chair Jerome Powell will address markets on Wednesday as policymakers will also release the Summary of Economic Projections.
Bull steepening, with bond prices rising, is considered a flag of trouble for the economy and can drive stocks lower. With inflation cooling, Powell has said policymakers are turning attention to the labor market, where private payrolls growth has been slowing. Recession fears were stoked by the July jobs report, and August payroll growth was less than expected.
A “50 will leave reporters in the room and investors behind their computers wondering if the central bank knows something they don’t” about conditions in the world’s largest economy, Torres said. “This is especially true considering the authority’s regulatory capacity and confidential information related to financial institutions.”
Under bull steepening, the shorter-term 2-year Treasury yield (US2Y) falls more than the 10-year yield (US10Y) as bond prices rise. Lower Treasury yields are likely to dampen the U.S. dollar’s (DXY) appeal and drive up the Japanese yen’s value (JPY:USD). Global investors still have fresh in their minds the quick appreciation of the yen and the unwinding of the yen carry trade that blew up markets worldwide early last month.
Torres said historical evidence points to a rate cut of 25bp being more favorable for risk assets. Also, “slow adjustments downward have been more friendly to equities than hasty moves south, with the former more supportive of soft landings and income stability,” the economist said. “At the same time, the latter has been associated with economic stress and bottom-line weakness.”
In the bond market Friday, the 2-year yield (US2Y), seen as sensitive to Fed policy, fell 5 basis points to 3.60%. This week, it hit its lowest point in two years. The 2-year yield has fallen from ~4.25% at the start of 2024. The 10-year Treasury yield (US10Y) on Friday slipped 1 basis point to 3.66%. See Seeking Alpha’s Treasury Yields page.
The U.S. dollar fell 0.7% to 140.83 yen (USD:JPY) on Friday. It bought ~141 yen at the beginning of this year.
ETFs tracking the benchmark S&P 500 (SP500) include (SPY), (RSP), (VOO), (SH) and (IVV).
Here are some Treasury ETFs: (TLT), (IEF), (SGOV), and (BIL).