Stocks were dragged down early on Tuesday after Trump tweeted attacks on China regarding its trade practices, providing hints that the current U.S.-China trade talks in Shanghai may face even stronger headwinds than previously thought. Despite this pressure, major stock indexes were only moderately down (and the small-cap Russell 2000 was up sharply) by Tuesday's market close, one day ahead of what's likely to be a pivotal interest rate decision by the Federal Reserve.
Here, let's take one last look at the latest market-driven probabilities before Wednesday's decision, courtesy of the CME Group's FedWatch tool. As shown on the simple chart below, there's a full 100% expectation of any rate cut. But here's where it gets more interesting. There's a 79.1% market probability of a 0.25% rate cut and only a 20.9% probability of a larger 0.50% cut. These probabilities have fluctuated rather widely in preceding weeks, but it currently appears that a very solid majority believes that there will only be a 25-basis-point cut.
Assuming that this base-case scenario becomes a reality on Wednesday, full market attention should then fall on the nuances of Fed-speak that will accompany the decision. Traders will hone in closely on what the future path of interest rates may be. Any talk of more aggressive rate cuts for the remainder of this year and beyond should be constructive for stocks. In contrast, any Fed backtracking on its expected rate cut trajectory should weigh on stock indexes. Two remaining scenarios are also possible: if the Fed opts not to cut rates at all, stocks should be heavily pressured; but if the cut is 0.50% instead of 0.25%, markets would very likely rally further to new highs.
One interesting divergence to note on Tuesday occurred with small-cap stocks. Large cap indexes like the S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite were all moderately pressured on Tuesday, as noted above. But small-cap stocks, as represented by the benchmark Russell 2000 index, rallied sharply.
This may be because trade wars generally have less of an impact on smaller, more domestic companies than they do on larger, multinational companies. Since one of the primary reasons for Tuesday's drop in the large caps was perceived trouble in U.S.-China trade talks, small caps didn't have that same pressure and instead rallied on the anticipation of lower interest rates on Wednesday.
As shown on the chart of the Russell 2000, the small-cap index just tentatively broke out above a large triangle technical pattern. Depending on how the market reacts to the Fed decision, any follow-through on that breakout could push the index at least to the next major resistance target around 1,618.
Bond Yields Brace for FOMC
We've been watching bond yields drop sharply since November of last year. Yields are closely tied to Fed interest rate policies. As the Fed has become increasingly dovish – from planning to raise rates to keeping rates steady to planning on cutting rates – yields have fallen in tandem. Now that the Fed will likely cut rates for the first time in more than a decade, yields will be very closely watched. Though the Fed's expected trajectory has been largely priced in, any surprises in the Fed's decision or language will likely affect bond yields.
As shown on the chart of the U.S. 10-year Treasury yield, it's been hovering just above the sub-2.000% multi-year low for the past few weeks. The prevailing trend and general directional bias continue to be to the downside. However, 2.000% stands as a major support level. If the Fed is less dovish than expected on Wednesday, we could be seeing yields rebound further off their lows.
Crude Oil Gushes Higher
Crude oil extended its rebound on Tuesday as the prospects of lower interest rates and a potential U.S.-China trade deal helped provide a brighter outlook for oil demand on the horizon. In recent weeks and months, crude prices have been hit severely both by data pointing to rising supply as well as concern that global oil demand will suffer due to a slowing global economy and trade wars.
As shown on the chart, U.S. crude oil futures have extended the rebound from the $55.00 support area. Overall, however, crude oil is stuck in a prevailing downtrend, and major moving averages continue to point decidedly down. Any further boost to the upside is likely to be met with strong resistance around the $61.00 level. To the downside, any breakdown below $55.00 support could push price down toward the next major support around $51.00.
The Bottom Line
If you'd like to know how interest rates and the Federal Reserve affect markets, Wednesday will be a day you probably won't want to miss. Depending on the Fed's rate decision, language in its statement, and subsequent press conference on Wednesday afternoon, we'll be watching for potentially volatile moves in stocks, bonds, the U.S. dollar, gold, and even crude oil, among other markets.
Like others, we're expecting a 0.25% rate cut and for the Fed to keep the door open for further rate cuts this year and beyond. But the markets will move based on how investors interpret the Fed's outlook and guidance going forward.
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