Danger is lurking in the stock market: A monster sell-off could be around the corner if the Federal Reserve doesn't deliver the rate cut the market expects next week.
That is because the market's so-called depth has become so shallow that it is increasingly vulnerable to exacerbated moves, according to J.P. Morgan. Market depth here is measured by the volume of orders on the bid and ask sides for the S&P 500 E-mini futures contract. A "deep" market is able to prevent a large order from moving prices significantly.
"In our mind, this persistently low market depth leaves U.S. equities vulnerable from here if central banks fail to validate market expectations or U.S. recession risks resurface," J.P. Morgan analyst Nikolaos Panigirtzoglou said in a note to clients last week.
The S&P 500 has risen a stellar 19% this year, but the strong performance has been accompanied by light inflows and trading activity as well as low market liquidity, the analyst pointed out. The average market depth has been close to historical lows, he said.
Market depth was as shallow last year when it experienced a few violent declines. In December, the S&P 500 dropped 9% in the month, briefly trading into a bear market on an intraday basis.
This time, an imminent risk for a vicious sell-off would be at the conclusion of the Fed's July 30-31 policy meeting. Right now, a rate cut is virtually a reality to traders as they price in a 100% chance of at least a 25 basis-point rate reduction next week, according to the CME FedWatch Tool. However, much of the market wants the Fed to cut even deeper.
The expectations for an easier policy were initially raised by Fed Chairman Jerome Powell, who said the central bank would do what's appropriate to sustain the current expansion. New York Fed President John Williams said last week it is better for central banks to take "preventative measures than to wait for disaster to unfold," which further fueled rate-cut hopes. The Fed later clarified that Williams was drawing from academic research, "not about potential policy actions at the upcoming FOMC meeting."