Over reaction...
US equities tumbled on Wednesday as the Federal Reserve reduced interest rates by 25 bps but signalled fewer cuts than previously projected for next year, sparking a market sell-off.
The S&P 500 and Nasdaq 100 sank by 2.9% and 3.7%, respectively, while Dow Jones, shed 1123 points, booking its 10th consecutive day of losses, its longest losing streak since 1974.
As the central bank lowered its forecast for the unemployment rate and raised expectations for core inflation and economic growth.
Semiconductors and healthcare sectors erased earlier gains, leaving all sectors in the red.
Nvidia pared it earlier gains to fall 1.1%, while UnitedHealth rose 2.9%, recovering partially from a 20% loss following its CEO’s murder.
The Fed cut by a quarter point today, in line with market expectations.
Stocks were crushed.
Yields spiked.
The dollar rallied.
Let's take a look at the culprit.
This is the Fed's latest "SEP" (Summary of Economic Projections).
Going in, we expected them to dial UP the 2025 end of year level of the Fed Funds rate, by a quarter point. They took it up by half a point.
That means they now see two cuts next year, not four. They see inflation higher now (highlighted in red). And they see growth a tick higher next year (also in red).
Remember, we talked about the Trump effect on the Fed back in 2016. Just a month following the Trump 1.0 election, the pro-growth Trump agenda influenced the Fed to a proactive rate hike in an economy that had averaged only slightly above 1% PCE inflation that year.
Also in that December 2016 meeting, the Fed revised UP inflation forecasts, saying “some of the participants” incorporated the “assumption of a change in fiscal policy” into their projections.
This time around, they've revised UP growth, inflation and taken two projected Fed rate cuts off of the table (a tightening effect).
It probably wasn't a regime change type of day, but Powell acknowledged that it was indeed a "new phase in the process" of finding the neutral level for rates. When asked if it was because of Trump, Jerome Powell revisited the script from 2016, begrudgingly admitting "some people" did "incorporate effects of policies into their forecasts."
Now, the market’s reaction reminded me of the shakeout from an inflation report earlier this year on February 14th (here).
In revisiting my note from that day, indeed we had another rare type of day - just the fourth time in four years that shared the features of 1) a down greater than 4% Russell 2000 and 2) at least a 14 basis point spike in the 10-year yield.
February 25, 2021. It was about inflation. The 10-year yield had risen from 1% to 1.6% in less than a month, and the move was quickening. The quickening was driven by the market's judgement that the additional $2 trillion fiscal package coming down the line from the new President and his aligned Congress was inflationary at best, and recklessly extravagant, at worst.
The $2.2 trillion Cares Act and the additional $900 billion in stimulus passed in December, before Trump's exit, had already driven a nearly full V-shaped economic recovery (by late January '21). The economy was projected by the CBO (Congressional Budget Office) to grow at a 3.7% annualised rate in 2021 (hotter than pre-pandemic growth), with an unemployment rate falling to 5.3% – about right at the average unemployment rate of the past 50 years.
The prospects of more, massive spending packages looked like an inflation bomb.
June 13 of 2022. It was a Monday meltdown, following a hot Friday inflation report. The Fed had just started tightening and was way behind the curve. Inflation was near 9%, the Fed Funds rate was below 1%. With a Fed meeting just days away, the market ratcheted up expectations for an aggressive 75 basis point hike. History suggested they needed to take rates a lot higher in order to stop fueling inflation, and start curbing it.
So, these two episodes (in 2021 and 2022) were clearly about significant inflation threats — potential runaway inflation. Now, let's contrast that with the two episodes from this year, which share the features of the 4%+ down day in small caps and the 14 basis point+ spike in yields …
What happened on February 13, 2024?
Heading into 2024, the Fed had telegraphed the beginning of the easing cycle, projecting three rate cuts for the year — while the market was looking for six. And the Fed then spent the month of January trying to curb the market's enthusiasm about the rate outlook.
With that, the inflation data reported that day came in a touch higher … and markets unraveled.
But unlike the two prior market episodes discussed above, the market reaction was unwarranted. The disinflation trend, at this point, was well intact. And the inflation data reported was the lowest level of the cycle, and a tenth consecutive lower year-over-year reading.
It was an overreaction. Stocks recovered in two days.
Yesterday's market reaction was, too, about the inflation outlook — but it's inflation that's well into the 2s, in an environment of high productivity, and (still) restrictive monetary policy.
So, while inflation is the common theme in these four episodes that share these rare extreme market reactions, it's fair to say the circumstances are quite different in these recent episodes, relative to the inflation backdrop of 2021 and 2022.
With that in mind, was the selloff in stocks (and bonds) an overreaction in a thin holiday market? It looks that way.