Fed Kicks Off Rate-cutting Cycle with a Bang – 5 Things to Know

Key Takeaways

• The Fed lowered its policy rate last week for the first time in four years. The larger-than-typical 0.5% cut signals a critical turning point in the monetary-policy cycle and a commitment to not fall behind the curve.?
• The Fed's proactive approach increases the likelihood of soft landing, as the projected string of rate cuts will lower borrowing costs for consumers and businesses over time, helping growth reaccelerate in 2025.??
• The start of a rate-cutting cycle that coincides with no recession has historically led to strong forward equity returns. However, because valuations are currently elevated relative to history, we think the upside will be more modest than previous soft-landing cycles.
• Cyclical, mid-cap and high-quality dividend-paying stocks may start to close the gap with mega-cap tech. Bonds will continue to benefit from lower rates over time, and investors should pay attention to the reinvestment risk of having an oversized allocation to cash investments.?

Some weeks are more consequential than others in shaping the market narrative, and last week was one of them. The Fed delivered on what markets have been hoping for and anxiously anticipating over the past two years. Interest rates were cut by a larger-than-typical 0.5%, signaling a critical turning point in the monetary-policy cycle. In response, stocks set new record highs, and the S&P 500 extended its year-date gains to near 20%, as investors embraced and applauded the move1. We offer five key takes on what last week's announcement means for the economy and markets.

1) Fed delivers supersized rate cut to jumpstart easing cycle

After the most aggressive tightening campaign in 40 years and the second-longest pause in history with rates in restrictive territory, the Fed cut its policy rate last week for the first time in four years1. Instead of the typical quarter-point move (0.25%), the Fed opted to lower rates by a larger half a percentage point (0.5%), taking the policy target range down to 4.75%-5.0% from 5.25%-5.5%.

The direction of travel was hardly a surprise, as Chair Powell had already signaled the start of rate cuts last month at Jackson Hole. The drop in the consumer price index (CPI) from a peak of 9.1% in June 2022 to 2.5% in August has given policymakers greater confidence that inflation is moving sustainably toward 2%. At the same time, the increase in the unemployment rate from 3.4% to 4.2% is a reminder that the Fed has a dual mandate, not only to achieve price stability but also maximum employment. As a result, the focus has now shifted from inflation to employment.

It was that focus on the labor market that led the Fed to cut by 0.5%, a decision that was not unanimous, as Governor Bowman dissented in favor of a smaller cut – the first dissent by a governor since 2005. While the larger cut was a surprise to most economists, the bond market was pricing in about a 60% chance of that happening the days before the Fed meeting1.

We think that the larger cut highlights the Fed's commitment to not fall behind the curve by keeping policy overly restrictive for too long. Partly it was a catch-up move, as Chair Powell suggested that a cut might have occurred in July if the Fed had the jobs data for that month in hand (the July jobs report was released on 8/02, two days after the 7/31 Fed decision). ?That said, Powell made clear that 0.5% cuts are not the norm, and smaller cuts remain the baseline for the upcoming meetings.?

The graph shows the projected path by Fed officials for inflation and policy rates, both of which are expected to decline over the next three years.?

2) Preemptive move supports the case for a soft landing

The last three times the Fed cut rates by 0.5% in a single meeting during an easing cycle was in 2020 in response to the pandemic, in 2008 in response to the financial crisis, and in 2001 in response to the popping of the tech bubble1. Clearly this time is different in the sense that the Fed is cutting rates because it can, not because it has to. The larger cut is not in reaction to recessionary conditions but rather an insurance against an unexpected slowdown in employment, with a goal to preserve the economic expansion.?

At the press conference Chair Powell expressed confidence about the fundamental conditions, saying, "The U.S. economy is in a good place and our decision today is designed to keep it there.” This positive outlook was also expressed in the updated Summary of Economic Projections, which showed that Fed officials still expect growth to stay resilient around the economy's potential (2%) and inflation to basically move back to target next year (2.1%). The unemployment-rate forecast was revised slightly up, now projected to peak at 4.4%. While this implies further cooling in the labor market, it remains in the neighborhood of full employment.

We think the Fed's proactive approach increases the likelihood of a soft landing, which has been our base-case scenario. While the impact of last year's rate hikes will continue to be felt for a while longer, economic conditions appear more helpful than hurtful, as interest-rate relief is on the way: 1) Consumer spending is still robust, as last week's retail sales showcases; 2) Jobless claims are low, pointing to a cooldown rather than a sudden deterioration in the labor market, with the rise in unemployment driven by an increase in the supply of labor instead of a jump in layoffs; 3) Household net worth is at record highs, boosted by appreciating home and stock prices; 4) Wages have been growing faster than the pace of inflation since May of last year, helping consumers maintain purchasing power; and 5) Unlike in 2022 and part of 2023, financial conditions and lending standards are easing1. All suggest that soft landing is not only possible but very likely.? ?

The graph shows the FOMC's updated projections. Fed officials expect growth to stay resilient around the economy's potential and inflation to move back to target next year, while the rate of unemployment peaks at 4.4%. Source: FactSet, September FOMC projections.

3) Not a one-and-done; Fed aiming to reach neutral rate by 2026

Last week's rate cut is a decisive first step in what will likely be a multiyear easing cycle with a goal to gradually remove restriction and reach a neutral point. The updated "dot plot" of interest-rate projections shows officials expecting an additional 0.5% of easing this year, most likely a one-quarter-point cut in November and another in December, followed by four additional cuts in 2025, and two in 20262. This path would take the fed funds rate down to 2.9%, a rate that Fed officials consider the neutral point. No doubt there will be deviations from that plan based on incoming data, and the Fed will only be able to tell the neutral point in real time as the economy reacts to the shifting interest-rate regime. Nonetheless, the upshot is that the Fed is eyeing a string of rate cuts that will lower borrowing costs for consumers and businesses over time, helping growth reaccelerate later in 2025 after a potential soft patch in the quarters ahead. ? ?

4) Fed easing is positive for stocks, if no recession

From a market perspective, the lesson from history is that equities' response to rate cuts depends on the state of the economy. The start of a rate-cutting cycle that coincides with no recession has historically led to strong equity returns six, 12, and 18 months after the first rate decline3. Examples of such instances are the cycles that started in 1984, 1989, 1995 and 1998. On the other hand, rate cuts in response to economic weakness and recession have been accompanied with losses, as in 1981, 2001 and 2007.

The graph shows the divergent path of the S&P 500 following the first rate cut of a new easing cycle based on whether the economy is in a recession or not. Past performance does not guarantee future results.?

Given our assessment of the current economic conditions outlined above, we think we are tracking the trajectory of previous Fed rate-cut cycles outside of U.S. recessions, not the trajectory of recessionary rate-cut cycles. The last time stocks were at record highs when the Fed implemented the first rate cut of the cycle was in 1995, and the S&P 500 went on to gain 23% in the 12 months after1. Historically, valuations have tended to rise after the start of easing. However, because valuations are currently elevated relative to history, we think the upside in stocks will be more modest than previous soft-landing cycles.?

The graph shows the price-to-earnings ratio for the S&P 500 which tends to rise after the start of Fed rate cuts. Past performance does not guarantee future results.?

5) Cuts highlight the opportunities for leadership rotations and the risks of having too much cash

With rates destined to decline in the coming years, areas of the market that have been punished from the Fed's aggressive tightening campaign could be the ones that stand to benefit the most. So far in the third quarter we have seen a subtle change in market leadership toward more balance than over the past year. While the shift in Fed policy has helped lift stocks broadly, it is a mix of defensive and cyclical sectors that have led the charge (real estate, utilities, financials, industrials), rather than the usual suspects (tech, communication services and consumer discretionary)1. In fact, the Nasdaq over the past three months is trailing the market-cap and equal-weighted S&P 500, growth is underperforming value, and semiconductors, a group that has delivered stellar results over the past year, is bucking the market trend and posting modest losses1.

As long as a recession is avoided, which we expect, the bull market in stocks appears poised to continue, with cyclical and lower-valuation stocks potentially starting to close the gap with mega-cap tech. Lower Fed policy rates and bond yields could also make high-quality dividend-paying stocks, like the S&P 500 Dividend Aristocrats, more attractive to investors. And mid-cap stocks that offer a nice balance among quality, valuations, and cyclical upside in case of an economic reacceleration next year, offer catch-up potential.

In the fixed-income space, the implications from a pivot to rate cuts are wide as well. The 2- and 10-year Treasury yields rose modestly after the Fed's outsized rate cut, possibly reflecting an easing in recession risks. Yet, bond yields remain near the lows for the year, and the path of least resistance is likely lower ahead. This pattern is reflected in the consistently positive returns for investment-grade bonds 12 months following the start of a Fed rate-cutting3.

Now that the Fed has moved and is promising more cuts, the reinvestment risk of having an oversized allocation to cash investments is more tangible. When a CD or a short-term bond matures six months or a year out, investors might have to reinvest the returned principal at a lower rate, earning less. This is why we recommend investors consider extending the maturity?profile of their fixed-income portfolios by repositioning where appropriate in intermediate- and long-term bonds.

The graph shows returns for different asset classes and indexes since the start of the third quarter. Market leadership has started to shift towards investments that carry lower valuations. Market indexes are unmanaged and cannot be invested into directly and are not meant to depict an actual investment. Past performance does not guarantee future results.?

Read the full Weekly Wrap here: https://www.edwardjones.com/us-en/market-news-insights/stock-market-news/stock-market-weekly-update

Sources: 1. Bloomberg, 2. September FOMC SEP, 3. FactSet, Edward Jones

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