Will the Stock Market Break Down if the Fed Disappoints?

Here's a comprehensive summary of the provided YouTube video transcript:

Key Concepts

• Market Performance: Analysis of last week's stock market performance (S&P 500, NASDAQ), crude oil, gold, Bitcoin, and currency movements (Euro, Yen, Dollar).
• Economic Calendar: Focus on upcoming economic data and events, particularly the US Federal Reserve (Fed) meeting.
• China's Economy: Discussion of China's trade figures, domestic demand issues, and deflationary pressures.
• US Consumer Confidence: Examination of the latest consumer confidence report and its implications.
• Inflation Expectations: Analysis of the dip in one-year inflation expectations and its historical context.
• PCE Inflation: Review of the Personal Consumption Expenditures (PCE) inflation data.
• ISM Data: Breakdown of the Institute for Supply Management (ISM) manufacturing and services indices.
• Fed Meeting Expectations: Market pricing for Fed rate cuts, particularly for the upcoming meeting and the outlook for 2025.
• Fed's Forward Guidance: Discussion of the Fed's reluctance to overpromise on future rate cuts and the importance of their outlook.
• Market Disconnect: The divergence between the Fed's projected rate cuts and market expectations.
• Risk Aversion: The dollar's increasing correlation with risk aversion rather than yields.
• Trader Positioning: The speaker's current trading positions in various assets.

Market Performance Last Week and Current Sentiment

The week began with a noticeable bout of weakness in stock markets, contrasting with the recovery seen the previous week. The S&P 500 was up only 0.3% last week, essentially flat, while the NASDAQ saw a 1% gain, significantly less than the nearly 5% jump from the week before. This occurred against a backdrop of rising yields, with the 10-year Treasury up 3% and the 2-year up 1.9%, suggesting renewed support at the long end of the yield curve.

Crude oil experienced a slight uptick last week but continues its broad, slow decline. The speaker, who is short crude oil, describes the movement as "annoyingly slow" and notes that the recent uptick doesn't alter the overall trajectory.

Gold stalled last week, which aligns with the movements in yields and equities. The prior week saw strong performances from gold, stocks, Bitcoin, and non-dollar currencies (with the exception of the Yen, influenced by Japanese fiscal policy). However, this momentum fizzled across most assets last week. The Euro, a proxy for dollar performance, slowed significantly. The Yen gained a modest 0.5%, and Bitcoin, a potential risk-on signal, fell 1.6%. While not a large move for Bitcoin, its defensive posture suggests a lack of follow-through in any risk-on sentiment.

Overall, the market sentiment this week appears to be driven by concern about upcoming events, primarily the Fed meeting.

Economic Calendar and Key Data Points

China's Trade Figures

China's trade figures were released, showing slightly better exports (5.9% vs. 3.8% expected) but softer imports (1.9% vs. 2.8% expected). The speaker emphasizes that the import numbers are more significant due to China's persistent issue with weak domestic demand and economy-wide deflation for nearly two years. Exports are not seen as a sustainable driver for China's economy, especially given trade disputes with major economies like the US and Western Europe, and concerns about dumping cheap goods due to anemic domestic sales. The export performance is viewed as a symptom of the problem, not a solution.

US Consumer Confidence and Inflation Expectations

A significant data point from last week was the stronger-than-expected US consumer confidence report, particularly the expectations index, reaching its highest level since August. This suggests a more optimistic outlook for US consumers. This optimism may be linked to a dip in one-year inflation expectations to 4.1%, the lowest since January. This marks the fifth consecutive month of declining inflation expectations. However, the speaker notes that sentiment hasn't found a firm bottom despite cooling inflation expectations over the past four months.

PCE Inflation Data

The updated US PCE inflation numbers showed 2.8% for both core and headline figures, which are stale data points and unlikely to significantly influence the Fed's calculus.

ISM Manufacturing and Services Indices

The ISM data from last week indicated that the services sector is still supporting the economy, with its index accelerating. The manufacturing sector, however, contracted slightly more than expected (48.2 vs. 48.6). The speaker highlights that while employment remains in contraction mode for both sectors, the prices component of the ISM data, though cooled, still appears relatively elevated compared to historical levels. This "prices component" is identified as a key factor for the Fed.

Federal Reserve Meeting and Market Expectations

The primary focus for the week is the Fed's policy announcement on Wednesday. Market expectations for a Fed rate cut at this meeting are very high, with an 89.4% chance priced in. This expectation has been consistently above 80% for some time.

Disconnect in Forward Guidance

A significant disconnect exists between the Fed's projected rate cuts and market expectations, particularly for 2025. While the Fed's September projections indicated only one rate cut for 2026 (down from 3.6 to 3.4), markets were pricing in at least two, and potentially three, cuts for 2025. At the end of last week, markets were pricing in around 64 basis points for next year, implying a strong possibility of a third 25 basis point cut after the initial two. However, over the weekend, this expectation shifted significantly, with only 52 basis points (barely two cuts) now priced in.

This shift in market pricing for 2025 is seen as a potential reason for higher yields, a stronger dollar, and a weaker stock market today. The markets may be anticipating a "letdown" from the Fed regarding its future outlook.

Fed's Reluctance and "Driving in the Fog" Analogy

The speaker suggests the Fed is reluctant to overpromise on future easing, drawing an analogy to "driving in the fog" – the Fed needs to slow down and be cautious due to the lack of timely and forward-looking economic data. The minutes from the October meeting revealed concerns among policymakers about embedding inflation expectations and a desire to avoid committing to further cuts, especially in December. While a dovish contingent exists (e.g., Steven Mirren advocating for larger, more frequent cuts), it's not the consensus view.

Potential Market Reaction to Fed's Decision

• If the Fed delivers 50 basis points: This is already priced in, so it might not provide a significant positive catalyst.
• If the Fed delivers three cuts: This would be a positive market response, but the speaker questions its likelihood given the Fed's apparent reluctance to commit to even two cuts.
• If the Fed sticks to 25 basis points and emphasizes a "meeting by meeting" approach: This would likely be perceived as a disappointment, potentially leading to further downside in the stock market, possibly retesting levels around 4,900, which was a break lower after the previous month's meeting.

Dollar's Role and Risk Aversion

The dollar has been increasingly acting as a creature of risk aversion rather than yields. If the Fed disappoints markets on rate cut expectations, it could drive the dollar higher due to a flight to safety and capital flowing into cash, with the US dollar being the preferred choice.

Trader Positioning

The speaker outlines their current trading positions:

• Trimmed bond exposure: Took off TLT exposure due to bearish price action, but may re-enter if the Fed provides a catalyst.
• Long gold: Still holding a small long position, despite some intraday weakness.
• Long dollar: Maintaining a long dollar position.
• Short pound and euro: Holding short positions in these currencies.
• Trimmed Aussie short: Reduced short exposure in the Australian dollar as it showed signs of breaking higher.
• Half short Bitcoin: Maintaining a partial short position in Bitcoin.
• Short S&P 500: Holding a short position in the S&P 500.
• Long silver: Still long silver.
• Short crude oil: Holding the "annoying" crude oil short position, which is making slow progress and has 11 days until expiration.

Conclusion

The current market weakness and rising yields appear to be driven by a growing realization that the Fed might not deliver the aggressive easing path that markets have been pricing in for 2025. The Fed's cautious approach, coupled with a lack of clear forward-looking economic data, suggests a reluctance to overcommit. This disconnect between Fed guidance and market expectations, particularly concerning the number of rate cuts in the coming year, is the central theme. A Fed decision that deviates from the market's highly optimistic outlook could lead to further downside in equities and a stronger dollar, driven by risk aversion. The speaker's positioning reflects a cautious, risk-off stance across several asset classes.