How the Fed's rate cuts and weakening job market impact stock trading in 2024

For the past two years, equity traders have been closely monitoring inflation reports, particularly the Consumer Price Index (CPI), as a key indicator of the Federal Reserve’s approach to managing the economy. The CPI measures changes in the prices of everyday goods and services, and during this period, inflation was consistently running well above the Fed’s target. In response, the Fed raised interest rates aggressively to cool down inflation, making it more expensive to borrow money. These interest rate hikes had a significant impact on stock prices, especially in sectors like technology, where companies rely heavily on borrowing for growth. Consequently, on days when CPI numbers were released, traders were glued to their screens, anticipating big moves in the stock market based on the latest inflation data.

Changing economic indicators: Shift from inflation to employment

However, the landscape is beginning to change. Inflation has been steadily moving closer to the Federal Reserve’s target rate, and as a result, the Fed is expected to start cutting interest rates soon. This shift has led traders to adjust their focus. With inflation cooling off, CPI reports are no longer the primary driver of stock prices. Instead, traders are increasingly concerned about the broader state of the economy, particularly the job market. The emphasis is now on whether the economy is strong enough to sustain growth without triggering a recession.

Impact of Fed's interest rate decisions

The central question now revolves around whether the Federal Reserve will cut interest rates in time to prevent a recession. While inflation may no longer be the dominant issue, the risk of an economic slowdown is becoming more pronounced. If the Fed delays cutting rates for too long, the economy could slow down significantly, leading to weaker corporate earnings, lower consumer spending, and ultimately, declining stock prices. Eric Diton, president and managing director of the Wealth Alliance, highlighted this concern by stating, “All of a sudden, inflation is no longer the big issue. The pivotal question for stock investors is whether the Fed waited too long to cut rates because recession risks are higher now than just two months ago.”

Market performance and increased volatility

Recent events in the stock market reflect this shift in focus. The S&P 500 Index, a benchmark for the broader stock market, experienced its worst week since the collapse of Silicon Valley Bank in March 2023. This decline was largely driven by sharp drops in major tech stocks, with Nvidia Corporation leading the fall with a 14% plunge. Additionally, market volatility, measured by the Cboe Volatility Index (VIX), has been on the rise. The VIX tracks how much traders expect stocks to move up or down and is often seen as a “fear gauge” for the market. After a period of relative calm, volatility is making a comeback, suggesting that traders are preparing for more turbulence ahead.

Shift in market expectations: From CPI to jobs reports

Interestingly, traders are now anticipating smaller stock market reactions to inflation data compared to employment data. As of last Friday, options traders were betting on a move of just 0.85% in either direction for the S&P 500 on the day the next CPI report is released. In contrast, they were expecting much larger moves, around 1.1%, ahead of the latest jobs report. This shift underscores how employment data has become a more critical factor for stock traders. A weaker job market could signal that the economy is slowing down more than expected, likely leading to more selling in the stock market.

Federal Reserve’s changing priorities: From inflation to employment

The Federal Reserve’s focus is also shifting. While inflation has been the main concern for the past two years, the central bank is now turning its attention to employment. The latest jobs report showed that the US economy added just 142,000 jobs last month, the slowest pace since mid-2020. This slowdown has raised concerns about whether the Fed’s interest rate hikes have overly restricted economic growth and whether they need to start cutting rates to avoid pushing the economy into a recession.

Anticipated Fed rate cuts and market reactions

Looking ahead to the Fed’s next meeting on September 18, traders are fully expecting the central bank to reduce interest rates by at least a quarter of a percentage point. The key question now is not if the Fed will cut rates, but by how much. Meanwhile, stock traders are increasingly focused on economic data related to employment and growth, employing various strategies to protect themselves against potential declines in stock prices. For example, the demand for out-of-the-money put options, which provide downside protection, has been rising. This indicates that traders are hedging against the possibility of a more severe downturn in the market.

Hedging strategies and elevated market risks

Traders are expecting higher volatility in the S&P 500 now, as out-of-the-money put options are in more demand relative to out-of-the-money calls, according to UBS data. Commodity trading advisers (CTAs), who typically capitalize on asset price momentum through long and short positions in the futures market, see little room to add to their positions from this point, according to UBS. The VIX is trading in the low 20s, a level that doesn’t necessarily signal immediate danger. However, it is 52% above its average reading this year, and the volatility curve implies elevated risk for the coming months.

Fed’s recent signals and economic projections

With Fed officials in a quiet period ahead of their next policy decision, there won’t be any commentary before September 18. However, the central bank’s latest Beige Book, which compiles information from business contacts in each of its 12 districts, revealed that business contacts are more concerned about slowing growth than inflation. Notably, there were no mentions of a “recession” and just ten “inflation” references—a low for 2024, according to DataTrek Research.

While consensus expectations are for the US economy to remain sturdy, the Atlanta Fed’s GDPNow model shows some slowing, projecting that third-quarter real GDP growth will climb to a 2.1% annual rate, down from roughly 3% weeks ago. This indicates a moderation in economic growth expectations, adding to concerns that the Fed may need to intervene sooner rather than later.

Navigating the new market landscape

The evolving economic indicators signal that the Federal Reserve needs to cut rates before it’s too late to prevent a recession. If the Fed doesn’t act swiftly, investors who have bid up stocks based on expectations of future rate reductions may face significant losses. This scenario is particularly concerning if fear builds in the stock market that central bankers are failing to adequately address an economic slowdown, which could eventually impact corporate earnings.

Eric Diton of the Wealth Alliance emphasizes, “Now everyone is watching every single data point on the economy and jobs. If it continues to come in weak, there will continue to be more selling.”