Go big, go early! How markets responded to the Fed’s big rate cut

You no doubt would have already heard about the US Federal Reserve’s interest rate cut overnight Australian time. The US central bank cut the Fed funds rate by 0.50% to a new range of 4.75-5%. This is the first time the Fed has cut this key interest rate since it responded to the COVID-19 pandemic in 2020. This article aims to examine the market’s reaction to the Fed’s move, and whether it has increased or decreased the expectation of future interest rate cuts.

A moderate surprise

This was one of the rare live Federal Open Markets Committee (FOMC) meetings where there were two possible outcomes, neither of which would have surprised the market all that much. A “live” meeting refers to a meeting where a change in policy is expected – up or down. For this September meeting, investors, via very short-term interest rate futures pricing, had already baked in at least a 0.25% cut, placing a 37% probability on this outcome and a 0.67% probability on a 0.50% cut.

Federal Reserve Chairman Jerome Powell described the rationale for the bigger cut as “recalibrating policy back down to a more neutral level”, and to “not get behind” the curve on removing some of the restriction it feels the previous setting was applying to the US economy.

If there was a surprise, it was in Chairman Powell’s comments around the strength of the US economy and the US labour market.  “The labour market is actually in solid condition, and our intention with our policy move today is to keep it there. The US economy is in good shape, it's growing at a solid pace, inflation is coming down, we want to keep it there”, he said.

If the US economy is in such great shape, and markets are wrong about recently growing recession fears, then why the big cut? Chairman Powell proposed “the time to support the market is when it’s strong”. In short, his comments indicate the Fed’s view is that inflation is moving towards its 2% target in an orderly fashion, and with inflation and economic factors roughly “in balance”, there isn’t a reason to continue with the degree of restrictiveness the previous policy rate implied.

Market reaction

Prior to September’s meeting, market yields have declined on growing fears the US economy is potentially headed for a recession. As discussed above, the Fed appears to be pushing back on these fears. So, did the market get the message?

A commonly used proxy for the Federal funds rate in the short-term is the US 2-year T-Bond yield. It peaked at just over 5.26% in October 2023 as inflation topped out, and again around 5% in April on worse than expected March inflation data. But since then, the US 2-year T-Bond yield has tumbled on generally weaker US economic data, accelerating its decline around the end of July. That move took stock prices with it in what has been described as a mini-crash at the start of August.

US 2-Year T-Bond yield through tightening and (now) cutting cycle

The chart above shows US 2-year T-Bond yield through the 2022 tightening and the now new cutting cycle. The fall since April is consistent with the market pricing in a lower Fed funds rate over the next 2 years. Note how the market anticipates – not follows – changes in Fed policy. At around 3.65%, the 2-year T-Bond yield suggests markets are expecting another 1.1% of cuts to come in the short term.

Note though, the 2-year T-Bond yield rose around 0.04% following Chairman Powell’s press conference, and stock prices as measured by the benchmark S&P 500 also pulled back. This suggests that the outcome, as well as Chairman Powell’s comments, were viewed as moderately hawkish (hawkish is the term commonly used to describe higher interest rates). Another way to put this is: Markets responded by factoring slightly lesser, not greater rate cuts in the short term.

Chairman Powell’s comments confirmed that the Fed does not view the US economy as being in any imminent danger, and that the size of the current cut is more about getting ahead of the curve and about “removing restriction”, rather than panicking over growing recession risks.

Still, the revised Statement of Economic Projections (SEP) issued by the Fed sees its funds rate at 4.4% at the end of this year and at 3.4% at the end of 2025. All things being equal, the Fed is telling us that further rate cuts are coming.

The market has moved to price this tacit guidance in, as shown in the CME Fedwatch Tool. The CME Fedwatch Tool uses pricing of very short-term US fixed interest securities to infer a range of probabilities for various Fed funds rate levels as at future FOMC meetings. 

CME Fedwatch Tool – Aggregated Meeting Probabilities before and after September FOMC meeting

I have stacked the Tools for prior (Sep 17 = above) and after (Sep 18 = below) the September FOMC meeting. Note that heading into the meeting, the market was sitting at a 37% probability of a 0.25% cut and a 63% probability of a 0.50% cut. This suggests a moderate surprise to the upside with respect to the 0.50% cut delivered.

The next FOMC meeting is on November 7. We can see the probabilities associated with this meeting (in yellow) have moved further towards the “4.4% by the end of 2024” SEP guidance, with the market increasing the probability for another 0.50% cut in November from 4.2% to 32% (i.e., to a Fed funds rate level of 4.25-4.5%).

December meeting probabilities (in green) suggest the probability of a further 0.25% cut at that meeting has grown from 63.5% to 77.4% (i.e., to a Fed fund rate level of 4-4.25%). Another way to read the December probabilities is to say that the market is pricing a 100% chance of a further 0.50% in cuts to 4.25-4.5% by the end of the year (i.e., roughly in line with the SEP).

Probabilities for further and larger rate cuts in 2025 have pared back modestly after the September meeting. March to September 2025 probabilities (in blue) all moved towards fewer/smaller rate cuts – potentially indicating the market is heeding Chairman Powell’s message that the US economy is nowhere near heading into recession.

Despite the pareback, 2025 Fed funds rate probabilities continue to skew towards cuts far deeper than SEP guidance of 3.4% by the end of 2025 – for example, the market is pricing a 100% probability of reaching that level as early as July. So, in conclusion, market pricing now either implies scepticism over the Fed’s confidence in the US economy, or that the market is expecting too much from the Fed with respect to rate cuts next year.

We have seen in the past that when the market doesn’t get what it wants from the Fed, it can throw a tantrum that translates to increased volatility in bond and stock prices. So far, on balance, the data on the market’s reaction to the September FOMC meeting suggests disappointment, not elation over the Fed’s “big” rate cut.