Will the Fed let markets fall 80%?

Markets have fallen in historic fashion in recent days. Are we headed for another descent into hell, or will the Fed cut rates and launch a new stock market boom?

Should we panic?

So how much should we panic about this fall?

Zooming out, we see that right now, even after this week's drop, shares are still up nearly 10% year-to-date.

And over the past year, even after this week, The market rose another 15.5% – an exceptionally good performance!

Why did the stocks go down?

We don't really know.

Stocks don't really need a reason to go down: U.S. stocks are quite expensive right now, historically speaking, and investors may simply have gotten worried about that.

On the other hand, the fall was global, which probably doesn't explain everything.

In Japan, where the price drop has been the most severe, approaching a full-blown “crash,” the story is actually quite clear.

Japan and rising rates

The Bank of Japan has raised interest rates as part of its attempt to prevent the yen from weakening too much.

Higher rates push down stock prices. In fact, it may have caused at least part of the global downturn, through a general panic or because over-indebted global investors have been forced to sell U.S. and European stocks to repay their loans when the price of their Japanese stocks fell.

Towards a US recession?

Let's come to the reason given by most financial journalists to explain the fall in prices in the United States. Almost everyone attributes the fall in stocks to the slowdown in the US economy.

Friday's U.S. jobs report, which showed a much sharper slowdown in hiring than Wall Street had expected, reinforced fears that the world's largest economy is under increasing strain from high borrowing costs.

Business executives signaled during the recent earnings season that consumers, who play a central role in the U.S. economy, are starting to cut back on spending.

High interest rates are supposed to slow down the economy. And when the economy slows down, corporate profits also decline, which pushes down stock values.

Unemployment still low

Every month, the Bureau of Labor Statistics asks businesses how many employees they employ. In recent years, that number has typically increased by at least 200,000 per month. But in July it only increased by 114,000 per month.

Does this mean the economy is slowing down? Maybe.

But it is also true that as an economy reaches full employment, that number must decline.

Once everyone has a job, we can't keep increasing the number of people with jobs!

The labor market is slightly weaker than a year ago, but not much weaker. Indicators of tension in the labour market have decreased, but they are approximately at the same level as before Covid, when the economy was strong. The employment rate of people of working age remains high and even increased in July.

So this doesn't look like an economy in distress.

Economy still solid for the Fed?

Now let's look at macro indicators.

Consumption is good, GDP growth is good, industrial production has accelerated. Only employment seems a little weak.

Labor productivity growth is also solid, standing at 2.3% in the quarter that ended in June. In fact, labor productivity is increasing at almost the same pace as GDP itself, suggesting that economic growth is sustainable.

In other words, There is some weakness in the labor market, but overall the economy looks pretty good.

So one might be wary of the idea that weak recessionary economic data caused stocks to fall.

What about the Fed?

The Fed should probably start cutting rates now, as the economy appears to be counting on it.

Interest rates affect stocks in two main ways.

First, interest rates are part of the discount rate – higher rates mean that future profits (or cash flows) are less valuable today.

Second, it is generally believed that high interest rates reduce aggregate demand, which slows down the real economy and reduces future profits.

In short, if interest rates are higher, it's bad for stocks.

It’s not just interest rates that matter: the future path of interest rates matters a lot. If it looks like the Fed is about to begin a long, steady process of rate cutting, that’s very positive for stocks.

But if it looks like the Fed is content to keep interest rates at 5.33% for the foreseeable future, that's a lot worse for stocks.

At present, There is a lot of uncertainty about the Fed's attitude.

Is the Fed ready to lower rates?

A slight rise in inflation earlier this year, combined with continued strength in the real economy, convinced the Fed not to start cutting rates.

Since April, however, inflation has started to decline again. Annualized inflation, by all standard measures, is falling again after that small surge.

And measured from one month to the next, inflation is now at or below the 2% target.

The Fed could respond in two different ways. The first was to say, “This looks good, but let’s wait another six months or a year to make sure that post-pandemic inflation has completely disappeared.”

Another would be to say, “Inflation is going down and unemployment is going up, so let's get ahead of the curve and start cutting rates now.”

Markets now expect the Fed to respond to recent slightly weak economic data by cutting rates in September.

Investors are betting that the Federal Reserve will respond to signs of economic weakness with more aggressive interest rate cuts.

Futures contracts involve a 94.5% chance of a half-percentage-point cut at this meeting, up from 74% on Friday and just 11% a week agoA week ago, investors were expecting only 0.75 percentage points of reduction this year, or three quarter-point cuts.

Can the Fed Hold Rates?

If the Fed doesn't start cutting rates soon, It will disappoint everyone's expectations and deal a blow to the real economy. If the Fed refuses to cut rates, it could surprise the business community to the downside and cause a recession.

The difference in interest rates between long-term and short-term bonds is usually a fairly reliable indicator of recessions.

When long-term bonds start paying less interest than short-term bonds – called a “yield curve inversion” – it means that people expect interest rates to fall in the near future..

Now, the most common reason rates fall is a recession.

An inversion of the yield curve that heralds a drop in rates?

Therefore, when the yield curve inverts, This usually means that there will be a recession soon.

In fact, the yield curve inverted several years ago, in 2022, and it has remained inverted ever since. In fact, It is very rare for the yield curve to remain inverted for so long without a recession occurring.

The yield curve inversion could simply be the result of markets underestimating the Fed's caution and expecting rate cuts that never materialized.

In other words, the yield curve inversion and last week's stock market drop could have the same cause.

The upshot of all this is that the Fed should probably start cutting rates now, as markets expect. Granted, the economic data is still pretty strong. But if the Fed continues to surprise markets by being tighter than expected, it could lead to a continued deterioration in the labor market and eventually a recession. In the event that the Fed cuts rates, we could expect another stock market and BTC boom!