What’s Next Now That the Cutting Cycle Has Begun?

The First Rate Cut Since 2020

The Fed cut the interest rate they control (called Federal Funds) for the first time since March 2020 – during the panic of Covid. They started with a larger half a point cut. That was the right call in my opinion as inflation is down to 2.6% year-over-year and unemployment is starting to trend higher. The 5.33% Federal Funds rate was starting to be highly restrictive as inflation moved lower.

Even with the cut and Fed Funds is sitting at ~4.8%, we are still historically restrictive because as inflation has moved lower, the gap or difference between it and the inflation rate has widened. That means that even with the Fed not raising interest rates any further they were allowing monetary policy to become more punitive on the economy.

Fed’s Plans for Further Rate Cuts

The Federal Reserve made it clear that they’ll be shifting to a quarter point cutting schedule going forward with two more cuts this year in November and December and a target rate of 3% at some point in 2026.

That’s a lot of mumbo-jumbo. Effectively, the Fed is reducing the borrowing costs for all entities as the Fed Funds rate is the base rate for all lending that takes place in the United States. The Federal Reserve uses the Fed Funds rate as a brake or gas pedal for the economy. The higher the rate, the harder they are pumping the brakes. By reducing it, they are taking the pressure off the brakes just a bit.

The concern for me is that in the June meeting, the members of the Federal Reserve’s Committee that sets the rate (“FOMC”) said that they believe it would be appropriate to cut once, by 0.25%, for all of 2024. Just three months later, they cut by twice that amount and expect another 2-3 cuts this year.

Why? It was really a somber story.

Dual Mandate: Inflation and Employment

The Federal Reserve has a dual mandate as issued by Congress. In other words, they have two responsibilities that they need to focus on. The first is they are tasked with keeping prices stable (fending off inflation) and the second is maintaining full employment. These two mandates tend to have an inverse relationship.

As noted above, when the Fed raises interest rates they are pressing the brakes to slow the economy and reduce inflation. At the same time, slowing the economy tends to cause job losses. The reverse is also generally true – that when the Fed is reducing interest rates, they are trying to stimulate the economy and the labor market, producing upward pressure on prices (higher inflation).

It's a delicate balancing act. 

The rationale that Fed Chair Jay Powell delivered was that they were shifting their focus from battling inflation to supporting full employment. Clearly, the labor market has been weakening as the unemployment rate has risen more than a point from the lows of last year.

The Fed called this “recalibrating.” He mentioned this word nine times in his prepared remarks. So what does the market tend to do when the Fed starts cutting rates?

According to data from Ned Davis Research¹: 

• Since 1974, stocks have been positive 80% of the time in the 12 months following the first rate cut, with an average return of 15%.
• When there is no recession, stocks are positive in every period after a rate cut, with an average return of 22% one year later.
• However, if a recession occurs, returns one year later are positive only 33% of the time, with an average return of negative 8%

That last bullet point is the key. So far, no recession.

Recession on the Horizon?

I was at a conference last week and the flagship speaker was Jefferey Gundlach, the founder of DoubleLine Capital, a large fixed income mutual fund shop. He stated that he thought the US was already or will shortly be, in recession.

Most economic indicators have been largely stable though, as noted, the labor market has been weakening. This is something I am keeping a close eye on as it can be an indicator of slowing economic activity.

The Fed is still attempting to thread the needle of a soft landing. My main concern is the lofty expectations embedded in this market. The economy is likely to experience some kind of growth, but recessions often come from an exogenous shock to the economy. More of a surprise than a slow build.

I’ve used this analogy in the past citing economist Hyman Minsky that stability breeds instability. In other words, recessions tend to be shocks in a seemingly strong economy. This is why the typical path for lower rates comes in the form of the Federal Reserve slashing rates because of some crisis. A soft landing is actually the rarer outcome.

What's to Come...

Thankfully, in the past when the Fed has cut rates near all-time highs, it has been followed by relatively good times. However, comparing today to historical instances is helpful but by no means a panacea. We’ve never truly seen anything like the current environment so a sense of caution should remain.

So, the likely outcome is that we either see a nice interest rate glidepath lower over the next two years towards 3.0% or it’s going to occur very quickly because there is some kind of crisis – a shock to the system. Those are the only two outcomes and while the former is the more likely at the moment, I think it is always wise to hedge our exposure

Thankfully, our strategy of taking advantage of the generational opportunity in bonds is working as planned. As rates have fallen, the value of our bonds has increased.

As always, we value your trust in us.

Sincerely,
Mark Asaro, CFA