December 20, 2024 | The Fed Shocks The Market Triggering an Abrupt Selloff

The U.S. Federal Reserve surprised markets this week with a small rate cut (expected), a forecast for fewer rate cuts next year and higher inflation (very unexpected).

This was a more hawkish report than the market expected.

The stock market reacted very negatively on Wednesday, with the S&P 500 losing 3 percent in just two hours. Bond yields moved higher.

Was the stock market selloff this week justified?

For the last few decades, the Fed has been using “market guidance” to massage the expectations of participants in financial markets. This means that traders, institutions and other participants are supposed to be able to anticipate the direction of interest rates and not be shocked by anything that happens.

But this time the market was caught off guard and it was not pretty to watch.

Of course, one could argue that markets were overdue for a selloff, and the Fed announcement was just an excuse. Everyone has been saying for months that the performance of just a few stocks — The Magnificent Seven — has been inflating the stock market beyond levels justified by fundamentals. So, this change in Fed market guidance is the excuse that traders needed to hit the sell button.

Another way to look at what happened on Wednesday is to point the finger at market participants and ask this question: What were you thinking the Fed was going to do? Keep cutting rates lower and lower when there was little reason to do so? Wouldn’t it make more sense for the Fed to save up room to cut rates aggressively if there is a recession? Right now, the stock market is strong, and the economy is in pretty good shape, unemployment is near the low end of the historical range and so on.

The Fed cannot cut rates to zero again. The consensus now is that the ZIRP was a serious policy mistake that led to a serious outburst of inflation. So, the lower limit is probably 2.5-3 percent for the Fed Funds rate this time, which means the Fed doesn’t have much room left for further cuts after this week’s move to 4.25 percent.

When there’s another recession the Fed wants to be seen to be doing something to help get the economy going again. Traditionally this has been to cut rates in big moves, quickly, to offset the lack of demand in the economy. This policy has worked primarily through the real estate market as a mortgage loan is the largest borrowing decision of most households. The housebuilding sector rebounds, and a new expansion cycle starts.

So, unless there is an imminent recession or a very large selloff in the stock market, the Fed’s hands will soon be tied. The market will just have to get used to a world where rates are not going to fall much more.

This is the last weekend note this year. We will return in 2025.

All the best for a Merry Christmas and a Happy New Year.

Hilliard MacBeth

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Hilliard MacBeth December 20th, 2024

Posted In: Hilliard's Weekend Notebook

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