The Stock Market Is Cratering. These Charts Explain Why.

Federal Reserve Chair Jerome Powell signaled last month that rate cut in December was no guarantee. (Alex Wong/Getty Images)

Key Points

• The stock market’s recent decline is primarily driven by fading investor expectations for a December interest-rate cut by the Federal Reserve.
• The probability of a December rate cut has dropped from near certainty in October to just over 50%, according to CME Group data.
• The absence of crucial employment and inflation data due to a government shutdown complicates the Federal Reserve’s ability to make a rate decision.

The stock market’s drop over the past few weeks seems unexplained at a glance, but the driver is hiding in plain sight: the outlook for interest rates.

All three major U.S. indexes, while mixed on Friday, are down from peaks hit this fall. The most aggressive declines are occurring in the S&P 500 and the Nasdaq Composite ; the technology-heavy index is down about 4% from its record high hit at the end of October.

The declines are largely driven by “momentum stocks,” or those that have seen large gains without extreme volatility. They periodically see drawdowns, as investors sell these assets and book profits, and then rotate into cheaper areas of the market. That type of explanation—essentially, that there has been more selling than buying—is one many on Wall Street have bandied about for the broader market, in the absence of a major news event that would explain the market’s swoon.

But there’s an explanation for the selling that has slowly, quietly emerged: Investors’ hopes for a December interest-rate cut have faded.

The probability that the Fed will cut rates in December have dropped from a near certainty in October to just over 50%, according CME Group’s data showing the federal-funds rate futures market. As those odds have gradually fallen, so have the indexes. The issue is the Federal Reserve might not lower rates as much as previously expected. That translates to less support for continued economic growth than the market had been betting on.

The probability of rate cuts has been very correlated to the MSCI USA Momentum index since May, according to Mizuho trading analyst Daniel O’Regan. As the probability of a December cut started to drop last month, the momentum index fell.

Stocks then continued to lose steam as it became clearer to investors that the Fed has little ability to lower rates next month. The government shutdown halted most of the employment and inflation data collection, which the central bank heavily relies on.

The funny part is the drift lower in the rate-cut probability has happened fairly gradually rather than all in one moment. It started when Fed Chair Jerome Powell said publicly in October that a rate cut is far from a foregone conclusion. As the weeks went on with minimal news on Fed comments and a lack of economic data releases, the probability kept slipping. Now, questions about whether the government will be able to put together October data linger.

Even if November data comes out, the Fed would prefer to have a more full slate of data covering a period of months to make a rate decision. As Powell said in October, making monetary policy decisions without much data is like driving through the fog.

The takeaway is that one of the pillars of the market’s multiyear bull run—a Fed that’s supportive of the economy—has cracked some, causing stocks prices to reset a bit lower. The market has to account for the risk that the Fed can’t cut rates so many times over the coming meetings, a disappointment that could begin with a pause in December.

The reality is that, while private sector indicators show the jobs market has remained weak over the past month, the rate of inflation is expected to remain above the Fed’s target. Combine that with the absence of data, and it’s difficult to envision that Powell and company will be ready to unabashedly throw support behind the economy.

The good news is the picture will become clearer soon enough. November jobs and inflation data will start the process and should hit the wires in December. The Fed’s next interest-rate decision is scheduled for Dec. 9-10. Even if the central bank pauses on cuts or shies away from issuing clear forward-looking guidance, it will comment on the data it has been able to get its hands on and explain what it’s zeroing in on going forward.

Until then, maybe the market will reflect all of the risks and then stabilize, as long as the picture doesn’t become any worse. The levels where buyers have consistently come in to support the indexes since September are around 22,000 for the Nasdaq, 6600 for the S&P 500 and $242 for the iShares MSCI USA Momentum Factor exchange-traded fund. Those are all just 1% to 3% below their current levels.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com