What if the FED cuts interest rates?

My Trading News weekly newsletter provides insights into the FED, inflation, and interest rates on a regular basis.

The significance of these topics lies in the fact that the FED is responsible for maintaining inflation below 2% to support economic growth. The FED utilizes monetary policy, particularly interest rates, to impact the Consumer Price Index (CPI), to keep inflation in check. With a dual mandate of stabilizing prices and reducing unemployment, the FED aims to adjust interest rates without negatively affecting the economy and potentially causing a recession.

Recent data in the U.S. indicates a 0.1% drop in June's CPI, the largest since May 2020, with the CORE CPI dropping to 3.3%, the lowest level since April 2021.

The market is now pricing in a 94% probability of a Fed rate cut in September.

Why is that important? In every single FOMC* meeting since 2009 the Fed has done exactly what the market was pricing in entering the meeting. So unless the odds change in the next two months, an interest rate cut is coming.

Who would benefit from a rate-cutting cycle?

1) Borrowers

Those who have credit payments are currently experiencing the impact of elevated interest rates. In the U.S., credit card interest rates are at 21.5%, which is significantly higher than the historical average by over 7 percentage points.

2) Auto industry

The auto industry heavily relies on financing for vehicle purchases. In the U.S. the current financing rate of 8.65% for a 4-year loan is the highest seen since May 2001. Any drop would leverage car sales.

3) U.S. Government

U.S. government faced a surge in Interest Expense on Public Debt, reaching $1.095 trillion in the last 12 months, marking a new record high. The ongoing disputes between Democrats and Republicans during negotiations on the U.S. Government Debt have put immense pressure on the Fed to consider rate cuts to alleviate this interest expense burden.

4) Businesses/stock market

Lower interest rates enable companies to fund their operations at reduced costs, leading to business growth and higher EBITDA. After June's CPI report, the market witnessed a significant shift where previous underperformers like small caps, value stocks, international investments, and regional banks emerged as winners, while former top performers such as large caps, U.S. stocks, growth companies, and tech firms experienced losses.

5) Bonds

Historical data from the last 9 rate-cutting cycles suggests that bonds are likely to benefit, with the Bloomberg US Aggregate showing above-average annualized returns in previous instances.

6) USD (U.S. Dollar)

A potential interest rate will impact the strong position of the USD against many major global currencies. A weaker dollar would limit Americans' purchasing power abroad, affecting areas from tourism to imported goods.

7) Investment

When interest rates are high, investors typically see a better return on their cash. Currently, bank account holdings in Europe or Asia may yield around 1% or 2%, while in the U.S. they are yielding 5%. As a result, investors are shifting their money to the U.S. and showing a preference for holding more of their portfolio in the U.S. rather than European stocks. When foreigners purchase dollar-denominated financial assets, they must sell their local currency and buy the dollar, which ultimately strengthens the dollar.

The dynamics behind dollar fluctuations are more complex than simply the Fed's interest rate decisions, as other central banks are also concurrently making choices regarding interest rates.

However, as the holiday season comes to a close, it is anticipated that markets will undergo changes, presenting significant profit opportunities for those who examine macro trends, analyze historical data, and make investment decisions within the confines of a sensible risk management strategy.

*FOMC = The Federal Open Market Committee is the division of the Federal Reserve that sets monetary policy by managing open market operations.