The Standard View
Currently, the market as a whole and nearly every market analyst believes that the Federal Reserve will cut US interest rates this coming week. I'm one of the few that thinks it might not and one of a slightly larger group that thinks that it shouldn't. The US economy is currently growing at potential - that 2-2.5% annual GDP growth - and there's no obvious slack anywhere in the economy. An increase in monetary stimulus here just isn't warranted. Time to leave well alone.
But that's not the standard view:
The Federal Reserve will probably cut rates this week. It could be the start of a summer rally in stocks.
Usually, the month of August is quiet for markets, as investors go on vacation. But this summer could be an upbeat exception to the norm if this week's expected interest rate cut sends the stock market off to the races.
The market has been excited about a rate cut for nearly two months.
Pretty much everyone does think there's going to be that rate cut.
Comments from Federal Reserve Chairman Jerome Powell and St. Louis Fed President James Bullard on Tuesday dampened hopes by some investors that the central bank would deliver a half-point interest-rate cut in July.
The speculation is all about whether there's to be a 0.25% cut or a 0.5% one.
Why There Shouldn't Be A Rate Cut.
There's simply no sign anywhere that there needs to be a rate cut. The only threat anyone can see to the US economy is Trump's trade wars. And they're not issues that can be dealt with by monetary policy in the first place.
In terms of what the Federal Reserve is supposed to be doing, they've a dual mandate. As close to full employment as we can be and as close to the inflation target as we can be.
The US is currently at full employment. There always is something called frictional unemployment - it takes time to find a new job, get hired, so there always will be some people unemployed while they do. The private sector kills about 5% or so - 7 million odd - jobs each year, the private sector creates about 5% of all jobs each year. What we record as unemployment is the flow between those. And there just is going to be a time period when some of those moving are recorded as unemployed.
We're also pretty sure that there aren't all that many people out of the workforce - out in the U-6 and the like measure of unemployment - who would like to be in it. We've just not got some stock of people we can attract into employment.
That is, we're at full employment.
The Fed's mandate is to be at 2% inflation. All along they've been telling us that they consider the best measure of inflation to use for this is core personal consumption expenditures - PCE without food and energy. This is currently running at 1.6%, 1.7%, and has been for some time. The inflation target is 2%. We're, in terms of aiming something as large as a national economy, right on target.
The Only Reason To Cut Rates Is Political Pressure
Of course, President Trump has been saying, very loudly, for some time now that interest rates should be cut. But that's why we've got central bank independence so that the politicians cannot determine what interest rates are.
But this leaves us with our problem. If interest rates are cut as a result of that political pressure, then that is an undermining of that central bank independence. And that's an important issue.
For one of the things that constrain inflation is that very idea that the Fed will pursue those dual targets without political interference. As soon as we all start to believe that inflation - as an example - will be subordinated to the whims of the electoral cycle, then we immediately bake into our evaluations of the economy political interference in inflation and interest rates. That means that for any given level of inflation, we require higher interest rates.
Something that's not good for the long-term health of the economy.
The Federal Reserve is almost unanimously expected to lower interest rates this week. I'm not so sure, I think good economics will overcome politics. Of course, it's entirely possible for me to be wrong here.
The Investor Takeaway
Buy the rumour and sell the fact is the way to invest in these sorts of changes in policy. The market is already well up on the idea that the Fed will cut rates. There's not actually much more upside if they do in fact cut rates. In fact, even if they do, I'd expect at best a plateau at this level if not a small fall.
And if they don't cut rates, as I think they shouldn't, then I'd expect the recent rally to fade away, with indices falling.
As far as I can see, the only analyst who agrees with me is Rex Nutting.
The markets have gotten so used to the Federal Reserve doing whatever it takes to keep the S&P 500 SPX, +0.74% and bond prices TMUBMUSD10Y, +0.00% rising that traders and investors are now expecting the Fed to go against its own judgment and aggressively cut interest rates at the end of July.
In putting a 100% probability on a cut in the federal funds target rate at the next Fed meeting on July 30 and 31, traders - and the economists who advise them - seem to have forgotten how language and math work. Not to mention economics.
Hey, maybe we're both wrong but that's indeed what I think about it. The Fed's been really pretty good with monetary policy this past decade, and I expect that to continue. They shouldn't cut rates, so they won't. Even if they do, I don't see markets rising much and they'll fall if they don't. Thus, I'm bearish on the indices.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.