Fed outsized rate cut draws muted reaction, but calm may not last

New York: Investors who anticipated furious market swings following the US Federal Reserve's bumper rate cut saw more of a muted reaction. That may be fleeting.

Traders had been facing high uncertainty as they awaited the expected rate cut on Wednesday, with a split between those expecting 50 basis points and 25 basis points. The Fed cut rates by an unusually large half-percentage-point.

But while market reaction was muted, with stocks and the dollar reversing positions to mostly come full circle, there could be another wave of action. Some referred specifically to bond yields being at risk of spiking higher after rising on Wednesday.

"The calm, I think is not going to last," said Brian Jacobsen, chief economist at Annex Wealth Management, which oversees $5.5 billion in assets. He pointed to a reversal in equities late in the day that could set the market up for weakness in stocks "unless and until we get some data giving us a clear sense of direction."

Jacobsen said the market will be focused on upcoming data such as Thursday's initial jobless claims. "The Fed clearly is in catch-up mode and trying to make up for lost time with the cut it's just made," Jacobsen said.

There may also be a knock-on effect as the Fed decision ripples through other markets. "The coming hours could prove dangerous ... with traders exposed to sudden riptides as rate expectations are reinforced in other economies,” said Karl Schamotta, chief market strategist at payments company Corpay, about foreign-exchange markets.

"Aftershocks are likely to continue as positioning-related adjustments play out."

Muted reaction

Stock options had priced in a roughly 1.1 per cent swing, up or down, for the SP 500, according to options analytics service ORATS. But by the close of trading, the index had snapped a seven-day winning streak to finish down 0.29 per cent, reversing earlier gains.

One reason for the muted market reaction on a close-to-close basis has to do with how asset prices moved in the days leading up to the Fed decision, said Sonu Varghese, global macro strategist at Carson Group.

Through Tuesday, the Russell 2000 was up 5per cent over the previous five sessions and the dollar had slipped 0.7 per cent, on expectations for the start of the Fed's long-awaited rate-cutting cycle.

"It's a very silly cliche, 'buy the rumor, sell the news', but that's kind of what happened," said Matt Diczok, head of fixed income strategy at Merrill and Bank of America Private Bank.

On Wednesday, the dollar index initially fell but recovered to trade up 0.1% at 100.981. "Since this policy move was mostly telegraphed, there is no outsized move in financial markets," said Jack McIntyre, portfolio manager at Brandywine Global.

Bonds did register a significant move, however, with the 10-year yield spiking by seven basis points on the day, while the 2/10 US Treasury yield curve reached its steepest level since July 2022, after the rate cut, signaling long-term expectations of higher inflation and growth.

Treasury yields, which move inversely to prices, had tumbled to their lowest levels since mid-2023 in the days ahead of the decision.

In a research note, Julian Emanuel, senior managing director at Evercore ISI, recommended positioning for a bounce in yields, and that progress by the Fed on inflation may slow or stall.

Small caps, which initially bounced, ended flat. Traders' initial reaction was to lift the small-caps-focused Russell 2000 index by nearly 1 per cent in the minute immediately after the Fed decision, making for the index's largest one-minute percentage gain in at least three months, according to LSEG data.

Smaller companies typically rely more on borrowing, and lower interest rates cut their financing costs, bolstering their profitability and growth.

"To see the jump in small caps specifically, that's the market buying what the Fed is saying, that they will continue to cut rates next year and that's a potential tailwind to small caps," said Ryan Detrick, chief market strategist at Carson Group.

But the Russell index finished up only 0.04 per cent on the day. Fed chair Jerome Powell said in the meeting that the rate cut marked a "strong start" to protecting strength in the economy.

Still, the outsized rate cut could be read more alarmingly.

"I do think that there will be a lot of profit-taking for investors that came into the day long equity to play this event and we may very well trade lower as the market continues to wonder what is scaring the Fed that we cannot see," said Matthew Rowe, head of portfolio management and cross-asset strategies at Nomura Capital Management.