Will the Fed Rain on the Rate-Cut Parade?

Market dreams of rate cuts may fade as crude prices and tariffs take center stage.

 

 

KEY TAKEAWAYS

• Fed meeting this week with expected update to Dotplot; median may shift from two to one cut
• Recent energy price spike due to Israel-Iran conflict adds inflation risk
• Tariffs remain a key inflation concern, curbing Fed’s willingness to cut
• Market had rallied back to breakeven on tariff delays and soft inflation prints
• Without the Fed as a catalyst, upside momentum looks limited

 

MY HOT TAKES

• The market is floating in a current, not running with momentum
• Crude oil is the sneaky inflation culprit that could delay Fed easing
• The Fed may not name Iran, but their decision will scream oil
• We could be one Dotplot shift away from another market pullback
• If the Fed isn’t the catalyst, we may not have one
• You can quote me: “This latest jump in crude comes at a bad time, when the Fed is feeling empowered to do nothing.”

 

Dotty, spotty weather forecast. No, I am not referring to the recent, soggy weather pattern here in NYC. My garden along with the multitudes of blowout hair stylists that line the strip malls in the NY suburbs certainly appreciate this recent weather, leaving the rest of us gloomy with dreams of sunny days ahead. The Fed’s FOMC is meeting this week and the committee members will share with us their views on sunny days ahead. Are they just dreams or will the sun elude us further?

 

I was asked in a recent interview what would be THE catalyst to drive markets higher. Equity indexes, you see, have made great bullish strides in recent weeks after bottoming out in early April. Those thin-air days were, of course, caused by peak-fear of tariff impacts. That fear, in fairness, may have been justified as the administration just ratcheted Chinese tariffs to 145% with “liberation day” still very large in the rearview mirror and the President showing no signs of backing off. Thankfully, that is history as the President soon after began to negotiate with US trade partners. While no meaningful deals have been inked yet, many tariffs have been temporarily reduced or delayed, and all sides seem to be interested in meeting on some common ground… at some point. Markets responded to the overtures with applause that landed the S&P and the other major indexes right around breakeven for the year..

 

The Big index (my pet name for the S&P) traded virtually sideways for several weeks in what looked like drifting in the current. Last week, it managed to drift through a major resistance level at round-number 6000, helped along by a series of benign inflation figures and some not-too-bad, monthly labor numbers from the prior week.

 

Last week’s trade could hardly be called positive momentum, but unfortunately, early-in-the-week gains were erased when Israel launched an attack on Iran. Markets generally respond to military conflict with initial declines. War means uncertainty and we know–because WE discuss it all the time–markets don’t like uncertainty.

 

But this time, it was more than uncertainty that caused markets to sell off. Looming in the backs of traders’ minds was inflation. Not just the plain-vanilla inflation we have been dealing with these past few years. No. Traders were thinking about energy inflation caused by a spike in crude prices. Did I forget to mention that crude prices jumped in response to the news of Israeli attacks? I know that I mentioned it in Friday’s newsletter / blog. Iran supplies crude oil, albeit illegally, and also has the potential to disrupt oil shipments out of the crucial Port of Hormuz. 

 

Headline inflation has been slowing… slowly over the past year and a half, helped along by disinflating and deflating energy prices, after being a major contributor to inflation from March 2021 through March 2023. Crude prices began to climb in ‘21 as demand increased along with OPEC-driven low supply. Russia's invasion of Ukraine pushed crude prices from the mid-60s per barrel to the mid-70s. The move exacerbated an already inflamed wound. Rising fuel costs would only make worse the already unmanageable supply-push inflation that was prevalent. The rest is kind-of history–kind of.

 

Inflation was slowly draining as President Trump won the ‘24 Presidential election. The Trump campaign was built around supply-side fiscal stimulus principles (known to be inflationary, but who doesn’t like stimulus). He also vowed to even the playing field in international trade. Shortly after his inauguration–as in the Monday after–the President began an aggressive tariff campaign. Tariffs, known to be an inflation driver, spooked the Fed which was already, for some strange reason… well, spooked. The potential for tariff-driven inflation saw rate-cut hopes sawed down in short order. Reason number 1 from the Fed: fear of inflation. This latest jump in crude comes at a bad time, when the Fed is feeling empowered to do nothing. Greater inflation fears are a problem for the Fed, which is responsible for keeping prices stable.

 

The FOMC is very likely to look closely at the implications from escalating tensions between Israel and Iran. Though we are not likely to hear about it in its policy-statement release on Wednesday, it is sure to come up in the Chairman’s post-release press conference. Even more importantly, I suspect that we will also see it–though not by name–in the Dotplot. 

 

You may recall that March’s Dotplot showed that the Fed was expecting two cuts before the end of the year. This morning, Fed Funds futures imply a 100% chance of one cut with a 90% chance of a second cut before year-end, which is kind-of aligned with the last Dotplot. What will Wednesday’s show? Well, there is a really good chance that the median projection will shift to only one expected cut this year, and the market may not take kindly to the admission. You see, right now, that bullish “catalyst” that I mentioned above, can really only be the Fed. Between tariffs and a now-projected increase in energy costs, the Fed may be more reticent to ease financial conditions further, in the near-term.

 

Even though it is just two days away, predicting what the Fed will predict for the year is an increasingly difficult challenge. There have been some promising developments in recent, hard economic releases as well from the soft ones that have been showing signs of improved sentiment. However the threat of tariff-driven inflation and the new prospect of rising fuel costs may overshadow these, leaving the Fed with no choice but to adjust down rate-cut prospects. 

 

This all leaves me wondering still, what will be the catalyst, if not the Fed, for a renewed bull market. Well, you will be the first to hear it from me when I figure it out. For now, I noticed that sun is forecast for next weekend giving me hopes of celebrating my birthday without the threat of rain… but hold on, that forecast just changed. 🤔

 

FRIDAY’S MARKETS

 

Stocks sold off on Friday on news that Israel launched an attack on Iran’s nuclear assets. Crude rose on fears of supply disruption while gold rose as a safe haven asset. Early attempts to recover were thwarted leaving equity indexes deeply in the red. Treasury yields gained slightly as Michigan Sentiment beat estimates showing signs of a recovery.

 

NEXT UP

• Empire Manufacturing (June) may have improved to -6.13 from -9.2.
• Later this week we will get Retail Sales, housing numbers, Industrial Production, and Leading Economic Index. The FOMC will commence its two-day meeting and release its decision on Wednesday. Thursday, markets will be closed for Juneteenth. Download the attached economic calendar for times and details.

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