Rate Cuts Are Coming! So...what does that mean?

Mark Basola, CFA?

August 30, 2024

Last week in Jackson Hole, Fed Chairman Jerome Powell said in no uncertain terms:

“The time has come for policy to adjust, the direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks.”

The Fed has 2 jobs, also known as a “dual mandate:” 1) price stability (keep inflation at their somewhat arbitrary 2% target) and 2) maximum employment (almost everyone who wants a job can find one). Over time, we’ve come to believe that the Fed has a third and almost unwinnable goal of market stability, but that discussion is for another day.

As we can see from Powell’s statement above, the dual mandate juggling act continues with main concern currently around the labor market. Per the Fed Chairman “upside risks to inflation have diminished, downside risks to employment have increased,” and “cooling in labor markets are unmistakable.”

Rate cuts historically mean turbulence on the horizon, though markets greeted the news with the Dow Jones up 1.1%.

Since 1945, the Fed has lowered rates (for a series of months or years) 17 times. On 12 of those occasions, a recession coincided with rate cuts, or was followed by the first rate cut.

Powell began raising rates in 2022 at a precipitous rate, understanding then that the greater risk to the economy was inflation, and that to cool inflation, the risk of higher unemployment and recession would have to be tolerated. But in July of this year, unemployment rose to its highest level in 3 years at 4.3% (still benign by overall standards, but the rate of increase has been notable).

It's important to note that the rate of inflation, though falling, is still at 2.9% according to the CPI metric, far above the 2% target.

The Fed is attempting to thread a difficult needle between its conflicting mandates of price stability (2% inflation) and full employment. Miss the price stability target too far to the high (or low) side, and you get social unrest, and miss the employment figure, you also get…social unrest. Getting a goldilocks “soft landing” will take some skill and/or luck.

On the other hand, the S&P has generally performed well, regardless of a potential recessionary environment.

?Implications

Look for the Fed to cut the Fed Funds rate from 5.50% to 5.25% in September, possibly even 5.00% if bad employment data continues to come in, with 1-2 more cuts likely in 2024.

Rate cuts theoretically should stimulate growth by lowering the cost of borrowing. However, there is reason to believe that given the fiscal and monetary position of the US, the stimulatory effect will be somewhat muted (see Lyn Alden’s July Newsletter). Most likely this will mean relief for leveraged businesses and consumers with short term rates, and perhaps carry over into long term mortgage rates (note the there is not a neat one-for-one connection between short- and long-term rates).

For markets at large, expect the reasons for the Fed rate cut (namely a weakening economy) to start manifesting themselves. While longer duration bonds will do well initially, keep an eye on inflation over the next year—if it picks up, the Fed will be in a very tough place. Market observer Sam Callahan noted on the Coin Stories podcast that at 2.4% CPI, bonds and stocks tend to be more highly correlated. We saw the worst year for the 60/40 portfolio on record, and further inflation may put the 60/40 portfolio on ice for years to come.

Investors should think about making sure to have an inflation hedge in place. It’s no wonder that gold recently hit an all-time high, and central banks continue to stockpile in part because of inflation concerns. Commodities in general should perform well in this environment—frankly anything scarce, such as certain desirable properties, should benefit. Publicly traded business with the ability to pass on costs should also be somewhat insulated. Long-term fixed rate bonds would be the main victim in this scenario.?

We’ll keep an eye on the data as this unfolds. Markets are inherently unpredictable, and the one thing we can predict is that a patient and properly built portfolio will trend upward over time, whereas aggressive speculation rarely wins.

For those readers who work with us, you know that it is vital to have a plan in place to steer the course through the volatility of the market. If you, your family or friends need a sounding board, we have a process and are happy to share our insight!?