Federal Reserve interest rates finally fall, nearing record Reuters

Mike Dolan’s Outlook for the U.S. and Global Markets

There’s not much left to say about the day’s main takeaways other than how they will navigate market reactions to the size of the Federal Reserve’s rate cuts and what Fed policymakers might expect going forward.

Few doubt that the first Fed easing of the cycle is imminent. Wall Street hit a new intraday record on Tuesday ahead of the decision, excited by the prospect of lower borrowing costs as the economy gains some momentum. Stock futures also held firm the night before the big decision.

What’s not to like?

A last-minute economic survey as Fed officials met showed retail sales unexpectedly rose again in August and factory output rose more than expected, reversing a more pessimistic survey of manufacturing last month.

Indeed, the Atlanta Fed’s GDPNow model has since raised its third-quarter growth forecast by half a percentage point to 3%, which is on par with how the economy grew in the second quarter.

Despite the buoyant market and strong economy, futures are still leaning towards a 50 basis point cut from the Fed on Wednesday, rather than the usual 25 basis point cut. With 40 basis points still priced in, the chances of a bigger cut are 60%.

Former Fed economist Claudia Thurm on Tuesday became the latest former Fed official to call for a big 50 basis point rate cut this week, arguing that the time to act is now to prevent unnecessary job losses and ensure the central bank’s twin goals are met.

“This Fed has placed great emphasis on the maximum employment aspect of its dual mandate,” Thurm said.

So, on the surface, big interest rate cuts are on the way, the economy is booming, inflation is returning to normal, and those perusing the Market Almanac are only seeing good things from it.

Of course, this time may be different, but the average one-year stock market return after the first Fed rate cut is almost 5%, even if a recession occurs, and the return is over 16% if the rate cut comes without any recession, which is the most likely scenario facing investors right now.

On the other hand, will stock and bond markets be unhappy if the 50 basis point cut favored by futures markets doesn’t materialize?

To do that, it may be necessary to see how the latest rate cut lines up with a “dot plot” of Fed policymakers’ future interest rate projections. If they simply postpone the total amount of stimulus to a future meeting and express confidence in the economy, markets may be quick to discount the move.

Some think that a signal of dissent in the “dot plot” could be important, especially if it suggests that the Fed has been less accommodative than some policymakers thought.

And of course, attention will be focused on the so-called long-term dot, recently set at 2.8%, which is widely seen as Fed officials’ estimate of a sustainable “neutral” rate that neither stimulates nor slows the economy, and is therefore important in calculating how the Fed thinks about the scope of the business cycle.

Before getting there, the government bond market calmed down a bit, with the two-year yield rising above 3.60%, more than 10 basis points above the two-year low hit on Monday. That’s almost enough to keep it at more than 141 yen above the year-to-date low for now.

The yen weakened further after disappointing Japanese trade data showed both exports and imports falling below expectations.

Stock markets around the world were broadly positive to positive, as were Wall Street futures.

British shares were slightly lower and the pound rose above $1.32 amid weaker performance in Europe as the Bank of England is not expected to follow the Fed’s lead on Thursday and its second interest rate cut this year is likely to be postponed until next month, when the new Labour government’s first budget is published.

Supporting this notion, UK inflation held steady in August, but the Bank of England’s closely watched services sector rose: headline inflation held steady at 2.2%, close to target, but services sector inflation rose to a higher-than-expected 5.6%.

But much of the attention on Thursday may be on the Bank of England’s latest annual outlook for reducing its bond balance sheet. It is widely expected to target a £100 billion reduction over the next 12 months, as it did last year. But in a potential boom for bond markets, a repeat of this target could mean a 75% reduction in active sales of UK government bonds, due to the large amount of debt that will automatically be redeemed.

Canada reported much better news on the inflation front on Tuesday, as the Consumer Price Index (CPI) reached the central bank’s 2% target in August, below expectations and raising hopes that the Bank of Canada will cut interest rates by 50 basis points next month.

Here are some key trends that are likely to give further direction to U.S. markets later on Wednesday:

* The Federal Reserve’s Federal Open Market Committee announced its policy decision along with its quarterly economic forecast and a press conference by Fed Chairman Jerome Powell.

* U.S. August housing starts and permits, July TIC data on foreign government bond holdings

*Policy decision of the Brazilian Central Bank

* International Monetary Fund First Deputy Managing Director Gita Gopinath speaks in Ireland

* US Corporate Revenues: General Mills (NYSE:)

(Reporting by Mike Dolan; Editing by Andrew Cawthorn; mike.dolan@thomsonreuters.com)