Stock Market Outlook: Fed Rate Cuts and Liquidity Concerns

The three major U.S. stock indices ended last week at record highs. The S&P 500 (SPX) has surged 33.75% from its April lows and is up 13.3% year-to-date, fueled by the market's absorption of policy uncertainty and continued optimism surrounding the artificial intelligence (AI) boom. Looser monetary policy has also provided support, with the Federal Reserve initiating a new round of rate cuts. However, a Morgan Stanley strategy team led by Mike Wilson warns that market volatility could ensue if the Fed's rate cuts fail to meet investor expectations. Traders currently anticipate at least another 50 basis points of rate cuts from the Fed from the current 4.00%-4.25% range this year. Federal funds futures markets also indicate that the official rate could fall to around 3% by this time next year. Wilson, however, argues that the U.S. economy may not require such aggressive rate cuts. "Our view has been consistent: the 'rolling recession' ended with 'Liberation Day,' and the economy is now in a transition to the early stages of recovery, and corporate earnings growth may be higher than expected," he says. Wilson believes the scope for upward revisions to corporate earnings estimates is widening, a trend that will align with improvements in indicators such as the ISM Purchasing Managers Index. "Economic areas (and market sectors) that have experienced weak growth over the past 3-4 years are showing increasing signs of pent-up demand being released, including real estate, short-cycle industrials, consumer goods, transportation, and commodities," he adds. Wilson argues that the Fed's current "easing pivot" differs from the conventional path in past economic cycles – primarily because the labor market, one of the two major components of its policy goal, has not deteriorated to the point of requiring substantial rate cuts, and the inflation rate remains stubbornly above the central bank's 2% target. "There is a contradiction between the Fed's policy response pattern and the market's need for 'rapid rate cuts,' which is a short-term risk facing the stock market; we need to be vigilant about this during the stock market's seasonally weak performance window," Wilson says. The stock market's desire for lower interest rate signals can be seen in the rolling correlation between stock returns and real yields – which is currently deeply negative. In other words, the market believes that "weak economic data" is beneficial for the stock market. The risk facing the market is that if the Fed recognizes the current economic dynamic of "transitioning from rolling recession to recovery" and decides that there is no need for such a large rate cut, the consequences will be dire. "Admittedly, this may be the correct decision from an economic perspective, but the market has already priced in more rate cut expectations. Therefore, from a market perspective, this outcome will be disappointing and may prevent the stock market from completing the full early-stage recovery rotation, which in turn will make it difficult for low-quality stocks and small-cap stocks to outperform relatively," Wilson says. Adding to the concern, liquidity is gradually drying up: the Fed is still proceeding with quantitative tightening (i.e., selling assets on its balance sheet), and at the same time, the U.S. Treasury Department is issuing government debt on a large scale, and corporate debt issuance is also high. Wilson says signs of liquidity stress may first appear in the "spread between the Secured Overnight Financing Rate (SOFR) and the federal funds rate." Traders also need to monitor the Bank of America Merrill Lynch MOVE Index (a measure of expected volatility in Treasury bonds) – which is currently at 72.5, near a four-year low, and if it rises significantly, it may mean that tensions are building in the Treasury bond market. "Although this does not seem to be a concern at the moment, we believe that liquidity pressures will first appear through these indicators; if the Fed does not respond to this potential risk, it may trigger a sharp and significant correction in the stock market," Wilson says.