Powell Leans Into Rate Cuts
Markets erupted with excitement after hearing Fed Chair Powell's speech at Jackson Hole on Friday, where he didn’t push back on restarting rate cuts as soon as the September meeting:
“The baseline outlook and the shifting balance of risks may warrant adjusting our policy stance.”
“This unusual situation suggests that downside risks to employment are rising. And if those risks materialize, they can do so quickly in the form of sharply higher layoffs and rising unemployment.”
Now, before getting too excited about Friday’s move, it's useful to have some context going into the event. For starters, markets were well hedged for a more hawkish tone from Powell than he delivered. Not to mention the S&P 500 riding a modest five-day losing streak. A survey of traders by Spectra Markets going into the speech showed 44% of respondents expecting a ‘hawkish’ message, and only 9% believed Powell would make a ‘dovish’ pivot. So, this was the big surprise, and investors were not prepared or positioned for it. However, the probability of a September rate cut only rose to 84% (from 73% coming into the day) and back to where it was when we got the dismal jobs report at the start of the month. Furthermore, the probability of getting rate cuts at the three remaining meetings increased, but not by much, to 37% from 25%.
Nevertheless, the Dow finally joined the other major averages in hitting a new record high while gaining 1.5% on the week. The small-cap Russell 2000 also surged to a 2025 high and ripped 3.3% for the week. Also registering a new all-time high was the S&P 500 equal-weight index, which rallied 2.0% last week, a solid sign of improving breadth. Not sharing in the excitement for the week was the Nasdaq Composite, which actually declined -0.9% on the week despite its +1.9% gain on Friday. The S&P 500 logging a modest gain of 0.3% for the week, while closing at the same level it traded at nearly two weeks ago.
This move in risk assets since the ‘Liberation Day’ panic has mowed over all doubters. It has rightfully humbled even the most eloquently articulated bears, but I think it's foolhardy for investors not to consider the current setup with a more balanced risk/reward posture. For starters, the VIX has collapsed to the low point of the year at 14.2…25% below the long-run mean and way below the peak of 60 back in early April (that was a great buying opportunity). A reading this low, while not extreme nor invalid, is an indication of elevated complacency (a high level of investor conviction). There are many legitimate reasons justifying why equities are trading at peak levels and near all-time high valuations – earnings, profit margins, AI (a potential life changing technology), business friendly administration, erratic tariff and geopolitical policy (but arguably effective), deregulation, global economic growth accelerating, and central banks around the globe stepping on the monetary policy accelerator.
So, no, I’m not sympathetic to the bears who find themselves on the outside looking in at this move to all-time highs in risk assets. However, given where we are now, I am shifting to a more cautious and balanced view and suggesting the bulls temper some of their exuberance. Friday’s move was nice, but now what? What’s the upside catalyst that isn’t already priced into markets?
Fed fund futures are priced for five rate cuts by the end of 2026 (to a 3.0% – 3.25% range), which is below the Fed dot-plot of 3.6%. So, now the Fed needs to deliver or risk disappointing markets. Or the data deteriorates in a manner that isn’t conducive to risk assets (i.e, recession risk rising). In a nutshell, we closed Friday with a whole lot of easing priced back into the forward curve, just as we had at the end of last year.
Inflation and the labor market are setting up a challenging minefield for investors and policymakers to navigate. Let’s start with inflation, which looks set to start inching higher over the balance of the year, and this is before we have much line-of-sight on how tariffs flow through the system. Here’s what Walmart’s CFO had to say during last week’s earnings call:
“As we replenish inventory at post-tariff price levels, we’ve continued to see our costs increase each week, which we expect will continue into the third and fourth quarters.”
No C-suite executive is willing to go on record at this time discussing pushing these costs increases onto the consumer for fear of being on the receiving end of President Trump’s wrath (remember when Amazon floated the trial balloon of including tariff costs with their pricing), but someone will bear this added expense.
That aside, market pricing via the 10-year TIPS inflation breakeven levels at 2.41% suggests that the inflation genie hasn’t been put back in the bottle. It is rare for the Fed to ease with market-based inflation views this high, which is why the long end of the Treasury curve remains elevated during this Fed cutting cycle.
As for the labor market, both the Fed staff and Powell on Friday see the unemployment rate at risk of moving higher. Rising unemployment, whether it be driven by a lack of supply (declining immigration) or falling demand for workers, will act as a drag on economic growth. Moreover, while initial jobless claims have been trending higher, they remain low by historical standards, and the JOLTS layoff rate, at a mere 1.0%, is close to the levels we were experiencing pre-COVID. At the same time, high and rising levels of continuing jobless claims attest to the fact that the mountain of unemployed are having difficulty landing a new job, and this is confirmed by the fact that the hiring rate, at just 3.3%, is considerably below the 3.9% prevailing rate in February 2020.
It's almost a setup where the Fed is ‘damned if they do’ and ‘damned if they don’t’ regarding whatever they do with the policy rate. Nevertheless, the market has already front-run the ‘good cutting cycle’ outcome and will need to adjust for all other outcomes (especially bad ones).
Equities are priced for the nirvana environment, where economic growth picks up in the back half of the year, earnings continue to grow at double-digit rates, tariffs won’t impact margins or volume, and participation will broaden out beyond the AI trade. Not to mention the welcome embrace of President Trump reverting back to the mentality he had in his first term, where he’s using the equity market as a barometer for his success – gone are the notions that this term was focused more on Main St. than Wall St. Equity investors are also hyped up on the fiscal adrenaline shot set to hit the economy as early as Q3 and continuing through the end of 2026 with the bulk of the stimulative elements in the OBBA frontloaded into ’25 and ’26. These are known positive catalysts already built into earnings and growth estimates.
Lastly, we have the US dollar index looking like it’s done going down and perhaps carving out a higher low around the 98 level. Sure, it was down big on Friday, but it’s nearly 2.5% above its early April low with the Fed pivoting to a more aggressive policy posture, inflation troughing, and a softening labor market – all variables that, on net, should be negative for the dollar – yet it’s no longer weakening. Not to mention the institutional investor community is carrying a large dollar short with a lot of capital positioned on the bearish side of the boat – a good spot for some disappointment and a potential turn up in the USD.
Don’t get me wrong – I’m not bearish. I’m actually pretty constructive over the intermediate to long term, but I’m not too enthusiastic about the near term until we get a healthy cleansing in some of the sentiment and positioning data.
Risk parity models are nearly fully maxed out in their equity exposure:
The same can be said for CTA’s:
The National Association of Active Investment Managers Index (NAAIM) is nearing its highest levels of the year and levels that in past marked peaks in equity exposure.
Over the past month and a half, markets have been susceptible to big headline events that have dominated attention and price action. Six weeks ago, it was all about Mega-Cap Tech earnings (META, AMZN, AAPL, MSFT, and GOOGL). A month ago, it was the jobs report. Two weeks back, it was the inflation data, and last week was all about Powell at Jackson Hole. This week, the focus will be squarely on Nvidia earnings and guidance on Wednesday afternoon. This company has truly become an enigma at a $4 trillion market cap and commanding a near 8% weighting in the S&P 500 (nearly a 5% weighting in the All-Cap World Equity Index and approaching the weighting of the entire Japanese stock market).
The chip giant has consistently guided next-quarter revenue above Street estimates (the share price is up over +30% for the year and an astounding +1,400% since October 2022) – we shall see if this streak gets extended because this will be needed if the stock and the market in general extend this latest bullish move to new highs. The bar is set high, seeing as Nvidia is expected to post a +48% YoY earnings-per-share boom in Q2 on revenue of $45.9 billion. Let’s also keep in mind what the message was from that recently released report from MIT, which found that nearly 95% of organizations are getting “zero return” on their investment in AI. To wit: “Just 5 per cent of integrated AI pilots are extracting millions in value, while the vast majority remain stuck with no measurable P&L impact.”
The broad market risk is that this (and subsequent) Nvidia earnings release(s) may indicate AI investment is peaking. Thus, a cautious outlook from CEO Jensen Huang would likely trigger a rush to book gains in broader asset markets. With 10 companies making up nearly 40% of the S&P 500, and 7 of those 10 being tech companies, it's fair to say Nvidia and the Mag7 have become the bellwether of AI enthusiasm with 40% of Nvidia’s revenue tied to Alphabet, Amazon, Meta Platforms, and Microsoft. This is what makes the equity market vulnerable at the moment, positioning and sentiment is heavily skewed to the bull camp. Leaving markets vulnerable to downside volatility on just moderately disappointing results. Like valuation, positioning data isn’t a catalyst, but rather a preexisting condition that matters to markets when a catalyst occurs.
For context, positioning unwinds or valuation resets do not constitute durable inflection points in a cycle. Sure, they can act as accelerators to a move should an inflection occur in a more meaningful fundamental variable, like economic growth, inflation, monetary policy, fiscal policy, and/or liquidity cycles. On these latter variables, I don’t see anything overly concerning coming through our work. The bottom line is that should some downside volatility occur, we’re inclined to risk manage it as best we can, but we stand ready to endure some short-term pain.
I won’t be penning a missive next week as I intend to take the long-weekend to unplug and decompress from markets for a couple days. Enjoy the holiday and safe travels to anyone hitting the road.
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