Can the FOMC Combat the Impact of Tariffs?

Major Moves

The U.S. stock market has had a rough two weeks. Beginning on May 22, bearish pressure started to mount as crude oil prices started falling and stocks in the energy sector began to lose ground. By the next day (May 23), the bearishness had spread throughout the market, and the major indexes started pulling back.

While many of the sectors in the S&P 500 have been moving in lock step with each other during these turbulent weeks, a few have stood out for either their out-performance or their under-performance.

You can see how this has played out in the hourly sector-comparison chart below, which uses the following sector-based ETFs managed by State Street Global Advisors:

  • Technology Select Sector SPDR Fund (XLK)
  • Real Estate Select Sector SPDR Fund (XLRE)
  • Consumer Staples Select Sector SPDR Fund (XLP)
  • Consumer Discretionary Select Sector SPDR Fund (XLY)
  • Health Care Select Sector SPDR Fund (XLV)
  • Materials Select Sector SPDR Fund (XLB)
  • Utilities Select Sector SPDR Fund (XLU)
  • Energy Select Sector SPDR Fund (XLE)
  • Industrial Select Sector SPDR Fund (XLI)
  • Financial Select Sector SPDR Fund (XLF)

As I mentioned, the energy sector – represented by XLE – has been the biggest loser so far. Stocks like Devon Energy Corporation (DVN), Noble Energy, Inc. (NBL), and Marathon Oil Corporation (MRO) have had to deal not only with the general bearishness in the stock market but also with the plunging price of crude oil. This one-two punch has sent traders fleeing to safer investments.

On the flip side, the materials sector – represented by XLB – has staged the strongest comeback out of any of the sectors, becoming the first sector to climb back and close in positive territory this week. Materials stocks have all been performing well this week – whether you're looking at Ecolab Inc. (ECL) or Newmont Goldcorp Corporation (NEM) – as corporate America still looks healthy and gold prices have shot higher as traders have sought safe-haven investments.

One of the biggest boosts, however, seems to have come from the three-way split of the former DowDuPont company – which was formed in 2015 by the merger of DuPont and Dow Chemical – on June 1. The company split into E.I. du Pont de Nemours and Company (DD), Dow Inc. (DOW), and Corteva, Inc. (CTVA) this week, and shares of DD rocketed higher as traders reacted to the DuPont board's approval of a $2 billion share buyback program.

Shares of DOW have bounced a bit higher, but shares of CTVA have been volatile and bearish as traders wonder how flooding in the Midwest and the trade war between the United States and China may affect agricultural margins.

Performance of sector ETFs

S&P 500

The S&P 500 soared higher today in a move that looks eerily similar to the bullish bounce the index experienced in early March. The S&P climbed 2.14% today to close at 2,803.27, just below the uptrending level the index broke down through to complete the its bearish head and shoulders reversal pattern last week.

While the index still has a number of resistance levels it will need to break up through to confirm a true bullish turnaround, today's move is encouraging. If it is anything like the move the S&P 500 experienced in early March, we could be in for a few positive weeks of trading.

Of course, all of that depends on whether the Trump administration moves forward with implementing its 5% tariff on all Mexican goods on Monday, June 10. But at least for now it appears traders believe there is more bark than bite in the current threat.

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Performance of the S&P 500 Index

Risk Indicators – Federal Funds Rate

If you want to know just how concerned traders are that the Trump administration's tariff policies are going to affect economic growth, look no further than the anticipated changes traders are pricing into the federal funds rate. The federal funds rate is the short-term interest rate the Federal Open Market Committee (FOMC) tries to control. Currently, the FOMC has a target range for the federal funds rate of 2.25% to 2.50% – or 225 to 250 basis points (bps).

So how can you tell what anticipated changes traders are pricing in? You look at the Chicago Mercantile Exchange's (CME) FedWatch tool. This tool shows, based on the price of various federal funds futures contracts, how likely traders believe it is that the FOMC will adjust the federal funds rate.

Until today, the FedWatch tool had shown traders believed the FOMC would leave rates unchanged until the group's December 2019 monetary policy meeting, at which point it would cut rates by 25 basis points (to a range of 200 to 225 bps). Today, the FedWatch tool is showing that traders believe the FOMC is going to cut rates as early as the July monetary policy meeting.

Looking at the chart below, you can see that traders are pricing in a 52.1% chance of a 25-bps rate cut and a 12.1% chance of a 50-bps rate cut. All told, traders are currently pricing in a 64.2% chance of an interest rate cut by July. To put into perspective just how quickly sentiment has been shifting on Wall Street, traders were only pricing in a 12.4% chance of a July rate cut one month ago.

If traders are correct, and the FOMC does cut rates early in the year, it may provide a bullish lift to the stock market.

Read more:

How Interest Rates Affect the Housing Market

How a Strong US Dollar Can Hurt Emerging Markets

What Are the Implications of a Low Federal Funds Rate?

Target rate probabilities for the July 31 Fed meeting

Bottom Line – FOMC vs. Trump Tariffs?

It's hard to look at the price action in both the stock market and the Federal Funds futures market today and not come to the conclusion that many traders are starting to believe the FOMC is going to try and protect the U.S. economy from the Trump administration's tariff policies by cutting interest rates.

I'm not sure whether everything is going to play out the way traders are currently anticipating, or if the FOMC will have enough fire power to withstand a U.S. trade war with Mexico, but this is a theme that will be worth watching develop during the next few weeks.

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