Inside Markets — Test for the Rotation

The rotation into cyclical/value and small cap stocks started on Friday after former Fed officials and the WSJ’s Nick Timiraos discussed the rationale behind a potential 50bp September rate cut. Typically, the Fed reserves a ‘double’ cut for emergencies or exogenous shocks with many participants concerned that a 50bp September rate cut could send the wrong signal to markets. Friday’s ‘coincidental’ policy headlines may have generated enough doubt in a widely assumed 25bp rate cut scenario to de-risk a 50bp cut. Why would the Fed cut rates by 50bp after two months of strong retail sales data? By most estimates, the Fed funds rate is at least ~200bp above neutral and Fed leadership doesn’t want to see any more softening in labor markets. The idea is that the funds rate should be closer to neutral so the Fed is in a better position to respond to risks as they emerge. We expect a dovish Fed message regardless of the size of tomorrow’s rate cut. But given where markets are currently priced, a 25bp cut tomorrow would likely result in higher bond yields and rapid unwinding of the recent rotation.

The SPX remains below its July all-time high and technical resistance at 5667. While we don’t expect it, a sustained close above 5667 would take the index to channel resistance levels in the 5735-5810 range.