Markets think the Fed will cut rates. Here’s why that matters

1. Easing time: Markets are pretty confident that central banks are about to enter a period of easing up on interest rates.

When the US jobs report came in well below expectations on Friday, stocks moved higher. The reason? It could clear the way for the Federal Reserve to start cutting interest rates.

Mark Cabana, rates strategist at Bank of America Merrill Lynch, said rates cuts are now all but assured. “It’s definitely happening,” he said.

Data from CME Group now indicates a 25% probability that the Fed cuts interest rates at its June 18-19 meeting. The likelihood that rates will be lower than current levels following the July meeting is above 80%.

It may seem counter-intuitive that a strong signal of slowing economic growth would push the US stock market higher. But in recent years, investors have become increasingly focused on the Fed, and the Fed alone.

“We have now reared an entire generation of investors that buy stocks because interest rates go down,” said Brian Belski, chief investment strategist at BMO Capital Markets.

The thinking: easier monetary policy will help boost borrowing, padding corporate earnings and possibly freeing up more cash for stock buybacks. But honing in on the Fed also carries risks.

For one, this cutting cycle will almost certainly look different than in the past. How it will unfold is difficult to predict. Central banks have significantly fewer tools at their disposal than they did a decade ago. In Europe, interest rates remain in negative territory and at record lows.

European Central Bank President Mario Draghi arrives for a meeting of Eurogroup Finance Ministers at the European Council headquarters in Brussels, Thursday, May 16, 2019. (AP Photo/Francisco Seco)

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The Federal Reserve has more leeway, but its benchmark rate — currently set between 2.25% and 2.5% — also leaves little room to maneuver.

Cabana thinks that because the Fed has less space for dramatic action, it will move to quickly cut rates.

“They know they have limited ammunition, therefore they need to get out ahead of it,” he said.

But it’s far from a settled debate. Others expect the central bank to move methodically and at regular intervals since it knows there’s little margin for error. In reality, no one knows for sure.

“We’ve never been in this scenario before,” Cabana said.

Another wrinkle is that bond markets are pricing in multiple near-term rate cuts from the Fed, according to Belski. Bond yields are already falling on that expectation, which could diminish the stimulative power of the rate cuts.

“If the Fed just delivers exactly what the market is expecting, then it’s not going to have an economic impact,” Cabana said. “The market’s already baked that in, and mortgage and borrowing costs are already lower.”

Not everyone agrees that rate cuts are a done deal. In a note Friday, PNC chief economist Gus Faucher said he thinks that the Fed will hold interest rates when it meets later this month. It may start cutting later in the year if June job numbers are also soft, he added.

One big question is whether it’s a problem that stocks seem to be decoupling from economic fundamentals. The divergence between stocks and bond yields implies that a correction could be in store.

2. Mexico tariffs: President Donald Trump has called off tariffs on goods from Mexico that were set to go into effect on Monday.

“I am pleased to inform you that The United States of America has reached a signed agreement with Mexico,” Trump tweeted Friday. “The Tariffs scheduled to be implemented by the U.S. on Monday, against Mexico, are hereby indefinitely suspended.”

The tariffs, which would have started at 5% and could have eventually climbed as high as 25%, were opposed by many members of the president’s own party and businesses that move goods back and forth across the border.

Markets could rally on the news. But the psychological impact of the skirmish may linger.

“The auto industry might have dodged a bullet with this one, but it’s not emerging completely unscathed,” said Ivan Drury, senior manager of industry analysis at Edmunds. “In many ways this situation underscores how rocky international production can be under the current administration.”

3. OPEC report: Oil prices are sinking, which means investors will pay close attention to OPEC’s monthly report on Thursday.

On the radar: What OPEC says about the forces driving prices lower, as well as any insight on supply by country.

Oil plunged into a bear market last week on concerns about excess supply and slowing economic growth.

Right now, a lot rides on whether Saudi Arabia can secure an agreement to extend production cuts, which could help prop up prices.

4. Coming next week:

Monday — US job openings; Chinese trade data
Tuesday — Uber (UBER) CEO Dara Khosrowshahi at the Economic Club of Washington; Dave & Busters (PLAY) earnings; Tesla (TSLA) shareholder meeting; E3 gaming conference begins
Wednesday — US and Chinese inflation data; US oil inventories; Lululemon (LULU) earnings
Thursday — German inflation data; Tesco (TSCDF) and Broadcom (AVGO) earnings; OPEC report; European Union industrial production
Friday — US and Chinese retail sales; University of Michigan consumer sentiment