Federal Reserve Expected to Stay on Pause — What Could Cause a Rate Cut?

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The Federal Reserve meets Tuesday and Wednesday and is expected to keep rates steady. But investors have been buying stocks partly because they expect the central bank to cut rates if economic data disappoint.

In the past three months the S&P 500 Index is up more than 7%, and the gain was larger before the coronavirus struck. The Fed has made clear it will lower rates if need be, providing support for the equity rally.

Economic data have been strong of late, with GDP growth trending above 2%, inflation running at just above 2%, and the consumer keeping the economy afloat.

Wall Street has been looking for yields to edge higher in 2020. Many expect the 10-year yield to move past the 2% mark, keeping its distance from the three-month, which is a positive economic indicator.

After moving slightly higher during the recent equity rally, the 10-year dropped to 1.64% as stocks dipped on the coronavirus development.

Still, the probability of an interest rate cut is just 12%, according to CME Group data. The question now is how likely the Fed is to cut later in 2020. Here's what to listen for when the Fed meets:

"What you need to look at in the language, and especially in the press conference, is any kind of a nod to potential reweakening in the global economic environment," said Danielle DiMartino Booth, former adviser to the president of the Dallas Fed and founder of Quill Intelligence.

"It was the global environment that gave them cover for the three rate cuts that they pushed through in 2019. And I would expect that they would fall back on that and continue to emphasize the strength of the U.S. economy."

Currently, two general risks to the economy remain a weakening consumer and a worsening manufacturing contraction, although there have been few -- if any -- strong indications that current economic forecasts are at major risk.

And while investors will listen to Fed Chairman Jerome Powell for any inkling that economic data may continue to decelerate - the trend since third-quarter 2018 - DiMartino says "all indications suggest that the consumer is going to keep going."

That's because wage growth has trended at a relatively strong 3.5% in recent months and housing-price inflation, a large portion of broader inflation, has been strong.

For investors, signs of economic strength will be a positive for stocks. But should the Fed see need for a rate cut - scary as it may be - stock prices would have a floor precisely because the Fed would indeed cut rates.