The Ghost of 1979's "Saturday Night Massacre": The Fed's Rate-Cut Hesitation Shows an Unwillingness to Follow Volcker's Old Path!

The Federal Reserve is facing a historic policy dilemma—rising oil prices driven by Middle East tensions are deeply influencing current decision-makers’ thinking, reminiscent of the emergency monetary policy action known as the “Saturday Night Massacre” in 1979.

As concerns about stagflation intensify, market expectations for a rate cut by the Fed this year have significantly diminished. Take the September policy meeting as an example: the implied probability of a rate cut in futures markets has plummeted from about 90% a month ago to 50%, a trend that has persisted through all of this year’s meetings.

Tonight, the Fed is expected to hold steady. The statements from Chair Powell during the post-meeting press conference and the economic forecasts from Federal Open Market Committee members may further clarify the policy outlook, but markets generally remain skeptical.

For investors, this means the “bad news is good news” trading logic of the past two years is breaking down. The rate-sensitive Nasdaq 100 index is only about 5% below its all-time high but has been nearly flat since mid-February—coinciding with rising Middle East tensions and declining expectations for rate cuts.

The Saturday Night Massacre: How Historical Lessons Shape Current Decisions

In October 1979, then-Fed Chair Paul Volcker convened an emergency meeting to aggressively raise interest rates to combat inflation. The global stock and bond markets suffered heavy losses, in what became known as the “Saturday Night Massacre.” The cost of this action was high: the U.S. economy entered a double-dip recession, Treasury yields soared, and President Jimmy Carter’s bid for re-election was jeopardized.

Volcker is a hero that Powell openly admires. Bond traders generally believe that the Fed is now viewing the situation through the same historical lens: a little prevention now is better than a costly cure later. No policymaker wants to repeat the mistake of being forced into extreme tightening like Volcker did.

The lessons of the 1970s are clear: inflation spiraled out of control amid two energy crises, and the Fed’s delayed and indecisive response ultimately inflicted severe economic and political costs.

Oil Price Shocks Reshape Rate Cut Paths

Ongoing tensions in the Middle East are transmitting through oil prices into monetary policy.

Bob Elliott, Chief Investment Officer of Unlimited Funds and a veteran macro hedge fund manager, wrote in a report: “Although many expect the Fed to turn dovish in the face of oil shocks, the best-case scenario is to hold steady, and if the situation worsens, the likelihood of rate hikes will increase.”

This sharply contrasts with the market narrative of the past two years. Even with stubborn inflation, investors have been eager to bet on the Fed cutting rates, interpreting weak economic data—including sluggish employment growth over the past year—as a “half-full” reason to keep buying stocks.

Since resuming an easing cycle in September 2024, the Fed has cut rates six times, including a 25 basis point cut in December last year. However, if the blockade of the Strait of Hormuz leads to further supply shortages, this could be the last rate cut for quite some time.

Stock Market Risks of Policy Shift Not Fully Priced In

Despite the significant decline in rate cut expectations, some market participants still seem to have not fully digested this policy signal. The Nasdaq 100 is only about 5% below its all-time high, indicating that valuations of large tech stocks have not fully reflected the tightening of the interest rate environment.

Apart from sectors benefiting from rising commodity prices, further deterioration of Middle East tensions would be purely negative for stocks. To truly shake the Fed’s policy stance, the situation would likely need to become “quite ugly.”