The upcoming Federal Reserve decision on July 31 is important because it will likely signal a shift in the Fed’s policy on interest rates and possibly the beginning of a new easing cycle. The main two questions market participants are focused on are: 1) What are the possible scenarios to expect from this Fed meeting? 2) Why is the Fed cutting rates in the first place?

The Fed speaks, and the market reacts

Before I get into the scenarios, let’s review the recent history because many people underestimate how much influence the Fed has on the stock market. For example, the main reason for the decline in Q4 2018 was when Fed Chair Jerome Powell said in early October he would raise rates three or four times over the next year. The market’s strength since early January was a result of Powell reversing course and saying he would be “patient” in raising rates. The decline we saw in May was after the Fed’s May 1 meeting when Powell did not give the markets what it wanted — which was to hint at a rate cut. Finally, the resumed strength we’ve seen since June was due to Powell hinting at an upcoming rate cut.

In their July 31 meeting, the likely scenario is for the Fed to cut rates by ¼ point. The most important part will be the Fed’s statement and Powell’s press conference after the decision. If he hints at more cuts over the next year, the market will embrace it and we will likely continue higher. If the Fed signals a “wait and see” stance with the possibility that this is a “one and done” rate cut, the markets will decline over the near-term because Fed funds futures are pricing in a few more cuts over the next year. If the market drops because it doesn’t get what it wants, the funny thing is it will eventually stop sliding when the Fed comes out and reverses their course again because that is the accommodative world we’ve lived in over the past several years.

The two possible scenarios we’ll see this week

Two other scenarios this week would be a ½ point cut or no cut, both of which are unlikely. A ½ point cut would of course be welcome by the markets but again, the statement afterwards will affect the direction over the near-term. No cut would shock the markets and probably lead to a 5%-10% decline. Again, we would only decline until market participants and politicians cry enough about it, thus leading the Fed to eventually cut. In other words, the market clearly owns the Fed and one would be foolish to think otherwise.

The expected rate cut has led to a heated discussion among economists and market participants. Many are confused about WHY the Fed is cutting rates when we supposedly have a strong economy and the markets are near all-time highs. My first response is the old saying “Don’t fight the Fed!” Stop being a macro economist and accept that we are likely moving back to an easing cycle. In other words, I prefer to take advantage of this accommodative environment because arguing with the Fed is futile.