Inside Markets — 50bp Rate Cut

The Fed policy statement indicated that 50bp rate cut was motivated by improving inflation and evolving risks to employment and inflation. The median dot in the updated SEP suggests an additional 50bp of easing this year (25bp in Nov and Dec) and 100bp next year, which would take the upper bound of Fed funds to 3.5% – still well above neutral (R-star), which was upwardly revised to 2.875%. Yesterday’s post-press conference pullback was attributed to a higher estimate of R-star and Powell’s assertion that the 50bp cut was not a reaction to recession risks. In fact, he mentioned multiple times that the US economy is strong and the labor market is simply cooling from overheated levels. This caused bond yields to rise off session lows and generated a sell-the-news response following last week’s ~4% rally in the SPX. Despite the immediate negative reaction to Powell’s press conference, the Fed’s policy message, updated dot plot and macro data just add support to the Goldilocks narrative that should be positive for earnings growth.

Over the past 40 years, the Fed has cut rates 12 times when the SPX was within 1% of its all-time high. In every occurrence the SPX was higher 12 months later with an average return of ~15%. In the first month, the NDX outperformed the SPX but underperformed on a 3-month basis. Interestingly, the Russell 2000 (RTY) outperformed the SPX on a 1-month and 3-month basis.

The RTY catch up trade is the most compelling opportunity in this market. After two years of extremely positive real yields and large cap dominance, the RTY finds itself nearly 40 percentage points behind the SPX in terms of performance. We began writing about the RTY catch up trade after the index broke above the upper bound of its two-year trading range in July. At the time, we questioned the sustainability of the move given falling copper prices. The RTY is a cyclically-sensitive index and the breakouts required cross market confirmation from something cyclical – like copper. The move higher in the RTY only has legs if copper prices are rising in lockstep. Copper prices are off August lows near $398 and now rising at $435 with a break above ~$440 confirming a near-term bullish trend. The RTY is now at 2253 with a sustained close above ~2265 confirming its near-term bullish trend.