Trading Day: Fed cuts, markets not sure where to look

By Jamie McGeever

ORLANDO, Florida (Reuters) -TRADING DAY

Making sense of the forces driving global markets

By Jamie McGeever, Markets Columnist 

U.S. markets gyrated sharply on Wednesday after the Fed cut interest rates by 25 basis points, and investors digested its new economic projections and Chair Jerome Powell's press conference. The upshot? Bond yields and the dollar rose, while Wall Street was mixed.

More on that below. In my column today I look at how a resumption of the Fed's easing cycle means the U.S. central bank is now swimming against the global tide. This may have mixed blessings for world markets. 

If you have more time to read, here are a few articles I recommend to help you make sense of what happened in markets today.

1. Fed rate cuts could set stage for broader U.S. stockgains 2. Fed may trip the stimulation wire: Mike Dolan 3. Trump has a point about Fed’s subpar inflation control:Jen 4. Ex-BoE deputy governor warns Trump could flick financialpayments 'kill switch' 5. China is sending its world-beating auto industry into atailspin

Today's Key Market Moves

* STOCKS: S&P 500 and Nasdaq fall, Dow and Russell 2000rise. * SHARES/SECTORS: Consumer staples, financials +1%. Infotech -0.5%, communications services -0.7%. * FX: Dollar index falls to lowest since February 2022.Euro tops $1.19 for first time in four years. But these movesunwind. * BONDS: Treasuries eventually fall across the curve,yields up as much as 8 bps in the belly of the curve. * COMMODITIES: Gold rallies to new high $3,707/oz but endsthe day nearly 1% lower following the Fed.

Today's Talking Points:

* Fed moves

The Fed delivered the quarter percentage point rate cut markets had expected, and it looks like there will be more to come. The emphasis on growing labor market risks and the new "dot plot" point to at least another 50 bps of easing this year.

But it's far from clear-cut. Employment and inflation risks are incredibly hard to gauge, and Powell said the Fed is in a "meeting by meeting situation". You can't read too much into the market's initial reaction on Wednesday, but yields ended higher and nearly 10 bps of implied easing was taken out of the 2027 rates curve.

* Rotation, rotation, rotation

The rotation out of Big Tech and growth stocks into small caps and cyclicals was a feature of the summer months but had cooled so far in September. It seemed to show its face on Wednesday, with the Dow and Russell 2000 closing higher and the Nasdaq falling 0.3%.

Where does it go from here, now that the Fed decision, revised SEP and Powell's guidance are out of the way? The Dow and Russell 2000 are still significantly lagging the Nasdaq and "Mag 7" this year, and relative valuations suggest there is room to catch up. But AI optimism might suggest otherwise.

* Tariff squeeze

The impact from tariffs on the U.S. economy has clearly not been felt yet. Retail sales in August were much stronger than expected, the Atlanta Fed's GDPNow model currently has Q3 growth tracking at a healthy 3.4% annualized rate, and Citi's economic surprises index has been positive for over two months.

The question is - and has been for months - when does this change? "Pass-through to consumers delayed but not derailed," say BNP Paribas economists, who estimate U.S. firms have so far shouldered 64% of the tariff burden and consumers only 17%. They see that changing to 1% and 63%, respectively. Will that move the dial?

Fed easing a mixed blessing for rest of the world

We're about to see a rare phenomenon in global central banking: the U.S. Federal Reserve is set to embark on an interest rate-cutting cycle just as many of its peers are winding theirs down. 

Strictly speaking, the Fed is resuming its easing cycle, having paused last December after announcing 100 basis points of cuts over the preceding three months. 

Regardless, the world's most important central bank is about to swim against the global tide, something investors haven't seen for many years, especially when it comes to policy easing. 

The rest of the world, therefore, may need to be prepared for some choppy waters ahead.  

There have been four large global easing cycles since the euro's launch in 1999, including the current one. In the previous three, the Fed was either one of the first big central banks to move, as was the case in 2019, or among the most aggressive rate cutters, as was the case in the dotcom bust. 

But last year the Fed was relatively slow off the blocks, as sticky inflation and solid growth meant it pulled the trigger after most of its peers. 

As a result, the Fed now finds itself playing catch up to other monetary authorities, especially against the European Central Bank and Bank of Canada, which have cut rates 200 and 225 bps in this cycle, respectively. 

Rates futures markets are currently pricing in around 150 basis points of Fed rate cuts by the end of next year, far more than is expected in the rest of the developed world. Traders expect only another 40-60 bps over the same period from the BoE, BOC, and Reserve Banks of Australia and New Zealand. 

Meanwhile, the ECB and Swiss National Bank are thought to be done, while the Bank of Japan is slowly raising rates, taking its own unique path.

This policy divergence may create some problems beyond U.S. shores. 

EUR-EKA! 

The most immediate and obvious market impact of the policy divergence is being felt in FX markets, as the dollar is weakening once again after a summer of relative stability. Unforeseen - and unwanted - domestic currency strength could complicate life for many central banks around the world.

Take the ECB. Officials are already expecting core inflation to undershoot their 2% target, ending 2027 at 1.8%. Much of the 15% year-to-date euro/dollar rise will already be plugged into their models, but probably not another jump higher in the world's most important exchange rate. 

The euro is already on track for its biggest annual rise against the greenback since 2003. If currency strength and tariff-sapped growth depress inflation even more, does that mean the ECB will need to start cutting rates again?

Perhaps. But that would risk lowering the policy rate, which is currently 2% and in the middle of the ECB's 1.75%-2.25% neutral range, into stimulative territory, something influential board member Isabel Schnabel has warned against. 

By some measures the region's 'real' inflation-adjusted interest rate is already below 'R-star', the long-run neutral rate that neither accelerates nor slows growth. You can see why Schnabel and others may be wary of further easing.

EUPHORIA?

And what about the impact on global equities?

Fed easing has historically been a tailwind for world stocks, when looked at purely through the policy rate lens. That's especially true when these rate cuts have been followed by 'soft landings' - i.e., no recession – which stands to reason.

The market already seems to be banking on this happening again.

Increasingly dovish Fed expectations combined with 'soft landing' hopes and optimism around artificial intelligence and Big Tech have helped drive a global equity resurgence since April. Many key indices have risen to new records, clocking impressive double-digit gains along the way. 

But how much of that is already 'in the price'? Some analysts reckon there could be more room to go.

Strategists at Exane believe equities are only in the "early stages" of an upswing that could culminate in "euphoria", and are overweight Europe and Japan. Their counterparts at Citi are "max long" equities on a global basis, with Europe replacing emerging markets as the main overweight position.

The risk, of course, is that the Fed fails to meet the market's aggressive easing expectations in the coming months, prompting the dollar to snap higher, global financial conditions to tighten, and a 'tactical' stock market correction to ensue, not only in the U.S. but around the world.

Only time will tell, but what is clear is that markets are entering unfamiliar territory. With many equity markets at record highs, bond spreads at historic tights and key exchange rates at levels not seen in years, investors should tread carefully as this latest Fed easing cycle plays out.

What could move markets tomorrow?

* New Zealand GDP (Q2) * Australia employment (August) * Japan machinery orders (July) * Taiwan interest rate decision * Bank of England interest rate decision * Euro zone current account (July) * ECB policymakers Claudia Buch, Isabel Schnabel and Luis deGuindos speak * U.S. weekly jobless claims * U.S. Philly Fed business index (September) * U.S. 'TICS' capital flows data (July) * U.S. Treasury sells $19 billion of 10-year TIPS

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Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.

(By Jamie McGeever; Editing by Nia Williams)