Four Reason the Fed Decision Caused Such A Deep Selloff
Markets dropped sharply following a Fed decision that met our “Hawkish If” scenario analysis, with the S&P 500 falling nearly 3% and the Russell 2000 dropping the most since 2022! There are four reasons the market dropped so sharply following the Fed decision, two that are based on positioning and two that are based on fundamentals.
First, above 6,000 the S&P 500 was priced for continued perfection and the Fed cutting rates less than expected is not perfection. We and others have been saying this market has been vulnerable to a pullback or “air pocket” should it encounter legitimate disappointment on core issues and that’s exactly what happened yesterday.
Second, the calendar. The S&P 500 is still up more than 25% YTD. Investors were positioned for a “met expectations” Fed meeting that would clear the path of a year-end melt up. The Fed cutting less than expected was a negative surprise and it likely caused some short-term focused traders to close positions out into year-end to secure gains, which added to the selling pressure.
Now, it’s not right to say yesterday’s declines were all trading/positioning driven. There are two fundamental reasons behind the declines, as well. First, the Fed is going to cut rates less than expected in 2025 and as I said in the FOMC Preview, that’s a legitimate disappointment (essentially the Fed will be a less-powerful bullish force for the markets in 2025). Second, there was a change in language in the Fed statement that some interpreted as the Fed signaling it may be done with rate cuts (this was the main fundamental reason for the steep drop in stocks yesterday). Bottom line, the Fed provided a legitimately negative surprise, and that combined with extended positioning and the calendar to cause a sharp drop in stocks.
Did Yesterday’s Fed Decision Weaken the Bull Market? No, I do not think so, and here’s why. Expectations and then the realization of the Fed rate cutting cycle were powerful bullish forces on markets in 2024. And for that to end entirely, markets have to believe the Fed is done with rate cuts. Put differently, it’s not so much the number of rate cuts that matters as much as it is the direction of rates (so as long as they’re still falling, the pace isn’t really that important).
To that point, the main fundamental reason for the drop in stocks yesterday was some interpreting the Fed’s change to the statement as implying the Fed may be done with rate cuts. I do not think that’s what occurred and there are two reasons why: 1) Fed Chair Powell stated, in his press conference, that rates needed to continue to decline. 2) Powell also stated that the FOMC believed rates were still substantially restrictive and the Fed wants to get them to neutral, and that means that rates will have to continue to decline. Those two statements by the Fed chair are much clearer than the words inserted in the FOMC statement and they speak to the fact that the Fed is still likely in a rate cutting cycle. Because of that, I do not view yesterday’s Fed decision as a substantial blow to the bull market.
Put differently, while fewer-than-expected rate cuts are a disappointment near term vs. market expectations, the facts tell me the rate-cutting cycle is still in place and because of that, Fed policy is still moving in a supportive direction for stocks. It’s just less supportive than it was before. This reinforces the point I’ve been trying to make about 2025, that we’re entering the new year with most positives realized and the key to continued gains in 2025 will be the maintaining of those positive factors, e.g. soft landing, Fed cutting cycle, falling inflation, solid tech earnings.
Pro-growth policies will be “kickers” on that positive set up, should they pass. However, this is not going to be the straight-line rally that we saw in 2024 and there will be bouts of doubt and disappointment caused by the Fed and economic data, and we saw that yesterday. Bottom line, markets will be more volatile in 2025 but the medium- and longer-term uptrend should stay intact as long as we can answer “yes” to the following four questions: Is economic growth stable? Is the Fed still in a cutting cycle? Is inflation still falling over the medium term? Are earnings still strong?
As long as the answers to all those questions are “yes,” then pullbacks, especially those that are 5%-10% in size, should be viewed as entry points for quality stocks. In sum, yesterday’s Fed meeting was a legitimate disappointment, but the steep drop in stocks was more a function of the S&P 500 being priced for perfection above 6,000 and not a legitimately negative change to the outlook. That said, we could see this decline continue in the near term if we get a negative surprise on data, including in tomorrow’s Core PCE Price Index. But despite the disappointment, the Fed is still likely in a cutting cycle, growth is still solid, inflation is still falling over the medium term and earnings remain solid. Until that changes the medium- and long-term benefit of the doubt remains with the bulls (although it may not be the smoothest of rides).
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