Economic Preview: Can the stock market march higher without the promise of more Fed cuts?

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Large-capitalization U.S. stocks have hit a new high this week, and significant credit for this feat can be given to the Federal Reserve.

Since the Fed instituted its first interest rate cut at the end of July, the S&P 500 index SPX, +0.06%  has shown remarkable resilience, rising 2% to a record high, despite the imposition of higher tariffs on Chinese imports, growing evidence of a global manufacturing recession and corporate earnings growth that has been flat at best.

But with the Fed almost certain to cut rates for a third time in as many meetings Wednesday, analysts fear that the central bank’s prescription of “insurance” cuts will have run its course, leaving the market without a key pillar of support, potentially setting the stage for a pullback.

“Looking at the fed funds futures market, investors are anticipating a few more rate cuts before the end of next year, whereas the Fed projections indicate this is the last cut before they go on hold,” Michael Geraghty, chief market strategist at Cornerstone Capital Group told MarketWatch.

Geraghty said that he is “sympathetic” to the Fed’s view that with unemployment at historic lows the stock market at record highs, but inflation below the central bank’s 2% annual target, a cut tomorrow followed by an extended pause is warranted. “Investors will have to reconcile themselves to the situation, whether that results in price turmoil remains to be seen.”

The Fed could avoid a negative market reaction by using its statement, and Chairman Jerome Powell’s press conference, to communicate an openness to further rate cuts. “If the Fed cuts and then says ‘the easing campaign is now over,’ the market would tank, but they won’t say that,” predicted Alec Young, managing director of global markets research at FTSE Russell.

Instead, the statement will leave open the possibility of another rate cut as soon as December, he said, while stressing that the Fed remains dependent on the incoming economic data when deciding on whether another rate cut is warranted later this year or in the first half of 2020.

The Fed funds futures market is placing a better-than-50% chance that there will be two rate cuts between now and June of 2020. These expectations raise the question though of just how aggressively the Fed can cut rates and still call them an “insurance” policy against a future downturn, and whether or not the Fed decisions are based on market expectations, rather than the other way around.

“If the Fed clearly signals that this cut is the last cut for sometime, then I’d expect it a pretty nasty reaction from stocks as markets want more rate cuts, and if markets can’t have more rate cuts they want flexibility for more rate cuts,” wrote Tom Essaye, president of the Sevens Report, in a Tuesday note to clients.

Geraghty argued, however, that tomorrow’s meeting could be a good opportunity to reassert its control over the monetary-policy narrative. “I think it’s very important for the Fed to signal their intentions clearly,” he said. “Otherwise you’ll drive stock prices artificially higher and the Fed doesn’t want a crash.”