Will the Fed Goose Markets?

Stocks jumped on Friday, building on strong weekly gains, as a weak jobs report spurred rate-cut hopes:

The Dow Jones Industrial Average traded 263 points higher, led by gains in Microsoft and Apple. The S&P 500 climbed 1.2% as the tech sector outperformed. The Nasdaq Composite gained 1.7%.

The U.S. economy added 75,000 jobs in May, marking the second time in four months that jobs growth totaled less than 100,000. Economists polled by Dow Jones expected an increase of 180,000 jobs. Wage growth also slowed.

“The market’s got a conundrum here. That’s a bad report. Just on the report itself, I think people would want to sell the market. However, the fact that it really makes the case for a rate cut, I think is why you’re seeing the market hang in there,” said JJ Kinahan, chief market strategist at TD Ameritrade.

Market expectations for a Fed rate cut in June rose to 27.5% from 16.7% after the data release, according to the CME Group’s FedWatch tool. The market is also pricing in a 79% chance of lower Fed rates by July.

The weak jobs number gives the Fed “a clear easing path by July, ” billionaire investor Stanley Druckenmiller told CNBC’s “Squawk Box ” before the jobs report was released.

Treasury yields fell broadly, with the benchmark 10-year rate dropping to its lowest level since 2017. The dollar slid 0.5% against a basket of currencies, trading at 96.54.

Bank shares followed yields lower. Citigroup slipped 0.9% while J.P. Morgan Chase and Bank of America slid 1% and 1.2%, respectively.

The major indexes were set to post sharp gains for the week as bets for lower Fed rates increased. The Dow is up 4.7% this week. It was also on pace to snap a six-week winning streak. The S&P 500 and Nasdaq were up 4.5% and 3.8% this week, respectively. They were all on pace to notch their biggest weekly gains since November.

Fed Chair Jerome Powell said Tuesday the central bank is “closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion.”

At this point, it's no longer a question of if the Fed will cut interest rates, but when. The US economy is slowing as trade tensions and the lagged effect of the Fed's rate hikes are only now seeping through the real economy.

Will the Fed cut once, twice or three times this year? I think once in July is already baked in the market but if stocks keep surging and leading indicators keep firming, the Fed might pause and wait.

The problem is US long bond yields keep dropping which signals the bond market is pricing in a more pronounced slowdown than the stock market, and that is a cause for concern.

Still, have a look at the weekly chart of US long bond prices (TLT), there's a double top forming and I'd be wary going long bonds here unless you see a deflation scare à la summer 2016:

Don't get me wrong, this is a very bullish chart for bonds but it seems like CTAs are driving this latest surge up in prices (down in yields) and this isn't sustainable.

Anyway, the rally in bonds and expectations of Fed rate cuts has bolstered stocks. Have look at the performance of the S&P 500 and its major sectors year-to-date:

It's kind of hard to scream for Fed rate cuts when financials are up 13%  and tech stocks are up 23% this year.

In fact, looking at the weekly chart of financial shares (XLF), I wouldn't panic if I was the Fed:

For me, the hoopla about Fed rate cuts is way overdone, the US economy is slowing, it's not falling off a cliff.

In terms of sector performance 12 months after the first Fed rate cut, Goldman's David Kostin says to focus on defensive sectors like Healthcare (XLV) and Staples (XLP) and momentum and low-beta factors which typically do well:

Lastly, keep your eyes peeled on emerging-market equities (EEM), they seem to be bouncing back up and that bodes well for global growth:

This too will give the Fed some breathing room before it decides to cut rates more than once this year. Unless there is a serious deflationary scare outside the US, it's hard justifying cutting rates three times this year.

All this to say, I'm not in full agreement with BofA that cutting rates now would be a "huge mistake" but I'm also not in the camp that says the Fed absolutely needs to cut rates right now.

The big risk if the Fed cuts rates too liberally is that it will fuel more risk-taking activity and another stock market bubble will develop. That never ends well but admittedly, it could take years before this happens.

Below, hedge fund legend Stanley Druckenmiller told CNBC on Friday that while the Trump administration’s tariffs may not appear that damaging on paper, their chilling effect on business sentiment could have an even greater impact on the economy and financial markets.

Druckenmiller also said stocks would plummet 30% to 40% if Bernie Sanders is elected president in the 2020 election. You can watch the full CNBC interview below.

I also embedded an interview with Druckenmiller which took place earlier this week at the Economic Club of New York. Soros's former CIO, Scott Bessent, who now manages Key Square Group asked great questions and it's worth listening to this exchange.

Lastly, the Economic Cycle Research Institute's Lakshman Achuthan explains why Treasury yields are falling in a special chart. Achutan says the Fed and the bond market are behind the inflation cycle's downturn and argues the Fed has plenty of room to ease.