Markets savor a big rate cut, but the main course awaits with Jay Powell

Markets

Stocks had a mixed Monday session as tech names hit a speed bump, with Apple dragging down the Nasdaq due to concerns over iPhone 16 sales. But the S&P 500 brushed off that tech stumble, inching toward record highs, while the Dow marched confidently to another peak. Investors seemed to be banking on a jumbo-sized rate cut ahead of the Federal Reserve's meeting, with optimism bubbling through the markets.

The labour market and inflation data haven’t exactly screamed for a massive cut, but that hasn’t stopped the market from placing its bets. With a 50bp cut looking like a sure thing, disappointment could be on the horizon if the Fed pulls back with a mere 25bp. The first cut is just the appetizer, though—the main course comes with Jay Powell’s press conference and the Fed’s dot plot, which will likely set the pace for the rest of the year.

Let’s rewind for a moment: those frantic 75bp hikes that sent the economy into clampdown mode were designed to wrangle inflation. Now, the market is itching for the Fed to loosen its grip to avoid the need for even bigger, back-to-back cuts if the economic data does swoon. Emergency cuts? That’s a word that sends shivers down Wall Street’s spine.

Meanwhile, quants and economists have been busy slicing and dicing CPI and PPI reports, landing on a Fed inflation gauge projection of around 0.15% for August. The takeaway? Rate cuts are long overdue.

Last week, the idea of a 50bps cut seemed outlandish, with fears that such a move would signal panic about the economy and spook the markets. But this week, that narrative has flipped. Markets are now cheering for the big cut, and after some well-placed media trial balloons, stock markets are soaring on the expectation.

Here’s the thing: investors are fixated on how fast the Fed will slash rates, thinking it’s the golden ticket to strong equity returns through year’s end. However, the real driver will be the health of the job market. For now, the market is bullish on rate cuts without a recession. But if a downturn does rear its ugly head later in the year, those same cuts could turn into bad news for stocks, flipping the narrative entirely. Will we see a Santa rally, or will investors find lumps of coal in their holiday stockings? Only time will tell.

Forex

The front-loaded dovishness is piling on the pressure for the dollar, particularly against the yen. On Monday, the yen surged to its strongest level since July last year, with the dollar briefly dipping below the 140.00 mark before clawing its way back toward 141. But the real intrigue lies in what’s coming next. Will the Fed keep the pedal to the metal with more aggressive rate cuts, or will they ease off, potentially giving bond markets—and long yen traders—a jolt?

This is the crux of the situation: will the Fed steer rates toward 3% or lower over the next year, or will they remain bound by a data-dependent approach, recalibrating with every new set of numbers? How the bond market reacts to this will be key, especially in the short-term currency markets, where every shift in yield expectations could send ripples across the FX space.

Oil markets

Despite the gloomy outlook in China, oil prices managed to climb, buoyed by the lingering effects of Hurricane Francine and the broader market’s optimism around a potential 50 basis point Fed cut. Traders are clinging to the hope that lower interest rates will keep the soft landing narrative alive, doing whatever it takes to fend off another growth scare. The theory is simple: lower rates reduce borrowing costs, potentially boosting economic activity and, in turn, driving up oil demand.

But theory doesn't always play out neatly in the oil market. In an oversupplied environment, with China's growth sputtering, even the prospect of rate cuts can’t change the fundamentals. Oil prices still bow to the most basic principle: supply and demand. And when supply remains abundant while demand wanes, as we're seeing with China, that optimism can quickly run dry.