Stock-market rally built on hopes for more big Fed rate cuts faces crucial test

By William Watts

A very strong September jobs number 'will definitely spook the equity market': Komal Sri-Kumar

Stock-market investors got what they wanted when the Federal Reserve delivered an extra-large September interest rate cut. A risk now is that strong jobs data in the week ahead could prove to be too much of a good thing, at least as far as Wall Street is concerned.

"If you do come up with a very strong jobs number...that will definitely spook the equity market," Komal Sri-Kumar, president of Santa Monica, California based Sri-Kumar Global Strategies, Inc., told MarketWatch in a phone interview.

It comes down to expectations for future interest rate cuts. Strong data could see investors scale back expectations for further monetary easing through year-end or beyond, marking a return of a dynamic in which good news on the economy is perceived as bad news for equities.

Market watchers may feel justifiably whipsawed. After all, many investors and analysts spent the run-up to the Sept. 18 Fed decision fretting that the central bank had fallen behind the curve. Separate economic growth scares in early September and late July-early August were pinned to fears of an imminent labor-market meltdown and a potential recession that could knock corporate earnings off track.

The problem is that while the Fed's decision to go with the jumbo-size 50 basis point cut to the fed-funds rate, rather than 25 basis points, did appear to soothe recession jitters, it also served to revive fears that inflation may not drop back to the central bank's 2% target soon. Markets-based measures of inflation expectations have ticked up, which helped to lift short, and in particular, long-term Treasury yields in the wake of the Fed decision.

See: Investors see risk that inflation hasn't yet been defeated

"Somewhat counterintuitively, aggressive cuts means bond yields should struggle to make new lows, as we have emphasized before," said Andrea Cicione, head of strategy at TS Lombard, in a Wednesday note.

"The Fed's new reaction function will see the market entertaining the idea of a reignition of growth and inflation next year, pricing in greater risk premium and more hikes for the next cycle," he said.

Moreover, despite the recent backup in break-even inflation rates and estimates of the term premium in the U.S. bond market, measures of potential inflation pressures remain low across the board, Cicione said, which suggests the risk of a higher inflation climate is not fully priced in.

Read: The 10-year Treasury yield is climbing after the Fed's big rate cut. Why investors should be concerned.

So far, the threat of a reignition of inflation isn't causing much worry among stock-market investors, Sri-Kumar acknowledged.

After all, inflation is often a boon to companies capable of passing on price increases to customers, he noted, but warned the tone could change if investors begin to scale back expectations for rate cuts in response to strong jobs figures or other robust economic data.

Sri-Kumar has been a critic of the Fed's decision to kick off its easing cycle with an outsize rate cut of 50 basis points on Sept. 18, a move he suspects was aimed at pleasing stock-market participants.

Fed Chair Jerome Powell, in his post-meeting news conference, convinced investors the big cut didn't belie fears about the outlook for the economy, but was a response to falling inflation. The problem, Sri-Kumar said, is that the Fed's big initial cut "let the genie out of the bottle" by conditioning the market to expect aggressive easing. Policymakers now risk causing significant disappointment if it appears they will be unable to deliver.

Stocks rallied the past week, with the Dow Jones Industrial Average DJIA ending Friday at a record. The S&P 500 SPX on Friday edged back from the record finish it set on Thursday, while the Nasdaq Composite COMP logged a weekly gain of more than 2%.

Equities were bolstered on Friday after the personal-consumption expenditures, or PCE, index - the Fed's favored inflation gauge - came in slightly lower than expected, showing a 2.2% year-over-year rise in August.

Fed-funds futures traders on Friday priced in a roughly 55% probability of another 50 basis-point rate cut when the central bank meets in November versus a 45% probability of a 25 basis point move, according to the CME FedWatch Tool. They have largely priced in a total of 75 basis points worth of cuts by year-end, with the Fed set to also meet in December.

Powell made clear in his speech at Jackson Hole, Wyoming, in late August that preventing further deterioration of the labor market is the top goal now that the other part of the central bank's mandate, price stability, appears in hand as inflation heads back toward 2%.

The jobs market has indeed showed signs of cooling. The U.S. economy added the fewest new jobs in the three-month period from June to August since the pandemic. And hiring is not expected to accelerate much soon.

Economists polled by The Wall Street Journal, on average, expect Friday's monthly jobs report to show nonfarm payrolls rose by 144,000 in September after a modest 142,000 the previous month and a paltry 89,000 in July. The unemployment rate was expected to stay at 4.2% in September. Fed policymakers will have the opportunity to digest another month's worth of jobs data before its Nov policy. 6-7 meeting, with October jobs data due on Nov. 1.

Investors may somewhat discount a strong jobs number on Friday. Recent benchmark revisions have undermined confidence in the data, while surveys of hiring demand are deteriorating and consumer-confidence surveys households are starting to feel the effects of a cooling economy, said James Knightley, economist at ING, in a note.

"If we see payrolls rise by 75,000 or less and the unemployment rises to 4.3% or 4.4%, expect the market to price in the prospect of swifter monetary policy easing - remember, the Fed is forecasting unemployment will end the year at 4.4%," he wrote.

Meanwhile, a significantly weaker-than-expected number would still likely be read as a negative for markets.

"We think it's still primarily the labor market that's the key issue," said Tom Hainlin, senior investment strategist at U.S. Wealth Management, in a phone interview. "If you were to see a material softening in the jobs report - a really weak September jobs report - that would be a bad news is bad news kind of release."

Other data ahead of Friday's main event may also move the needle. Powell and company are seen sensitive to readings on job vacancies, so investors will pay heed to Tuesday's job openings and labor turnover survey for August - known as the JOLTS report. Tuesday also features the release of the Institute for Supply Management's closely watched manufacturing index. Weak readings the past two months were blamed in part for market pullbacks.

Related: Why stock-market investors are freaking out over economic data they used to ignore

And the week kicks off with remarks from Powell himself, who is slated to speak at an economics conference Monday morning.

But in the end, the best outcome in the near term may be a report that doesn't stray far from expectations either way.

"A sizable miss could undoubtedly lead to a narrative shift in markets of an upcoming downturn, but a sharp gain could push rate reductions further out on the curve," Jose Torres, economist at Interactive Brokers, summed up in a Friday note. "The ideal scenario for bullish investors is a figure close to projections, as it won't disturb current monetary policy easing expectations."

-William Watts

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09-29-24 1201ET

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