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The Fed made a remarkably dovish pivot over the first half of the year and is widely expected to cut rates 25 bps to 2.00%–2.25% at the July 30–31 meeting. Markets now place 85% probability on two or more rate cuts in the second half of 2019. Yet while financial markets have gotten a boost from this policy shift, we see reason for caution, not celebration. Looking ahead, we see risks that the Fed adds to market uncertainty instead of offsetting it, a situation that could ignite significant volatility.

One risk is that significant Fed rate cuts are already priced in, meaning any indication the Fed will not cut as much as expected will be painful for equities to unwind. Additionally, there seems to be little consensus from Fed officials to explain this newfound dovish stance, which raises the risk of muddled Fed communication – a historically famous cause of market volatility. Then there is the risk of cutting rates that are already near historic lows. Each cut expends valuable ammunition should the economy face a deeper contraction.

Perhaps the biggest risk right now is to the Fed’s credibility, which is arguably the backbone of U.S. monetary policy. At what point are Fed rate cuts no longer about supporting the economy, but about supporting the stock market? If the equity markets view the Fed’s continued monetary easing as a sign of weakness instead of strength and stability, it could be a short-term gain but would be corrosive to the Fed’s hard-won credibility, which could cripple monetary policy in the long run.

In the end, whether the Fed delivers one or more rate cuts this year, risks of a policy misstep seem unusually high for such a traditionally disciplined institution.




Read the analysis for each indicator:

The corrosive effects of policy uncertainty

Trade tensions
Monetary policy
Interest rates

Sentiment indicators are more important than ever

Business sentiment
Consumer confidence

Don’t ignore key recession indicators

Yield curve inversion
Initial jobless claims

Equity volatility looms, high yield stands to benefit

Equities
Fixed income

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