The Fed Finally Made its First Cut
The first cut in the Federal Funds rate this cycle is now in the books. Investors were positioned for about a 60% chance that the Fed would move by 0.5% instead of 0.25%. An additional 1% cut to interest rates is expected for 2025 on the way toward the Fed’s longer-term goal of 2.9%. Stock markets ended the day down 0.3% but are indicated higher this morning by 1-2%. The 10-year yield actually rose slightly yesterday to a bit over 3.7% as the yield curve steepens further from a previously inverted position. In his press conference, Chairman Powell noted that we should not expect 0.5% reductions at a time to be the new normal pace. That is as long as inflation remains headed toward 2% and unemployment does not ratchet up significantly.
Summer formally ends this Sunday and winter and skiing season are not that far off. We are reminded that when you get to the top of the mountain and exit the ski chairlift, at some point you have to commit to skiing down the hill. You can wait for the weather to change, the winds to slow down or the snow squall to pass. The Fed started raising interest rates in March of 2022, over 2-1/2 years ago, and reached the apex of the interest rate cycle in July of 2023. Since then, the Fed has been surveying the landscape waiting for the right moment to plunge down the hill toward a new rate cutting cycle. The Fed noted that recent indicators suggest that economic activity has continued to expand at a solid pace. Inflation has made further progress toward the Fed’s 2% goal but remains a bit elevated. However, the unemployment rate has moved up and job gains have slowed, leading to heightened concern over its full employment mandate and the reason for a larger initial rate cut. At least now, the risks to achieving its employment and inflation goals are roughly in balance. There is plenty of powder to keep the momentum going, but it will be difficult to reverse course if inflation flares up again.
Economic Indicators are Cruising Along
If we survey the economic landscape, the Atlanta Fed estimate for Q3 GDP is for 3% growth, following 1.4% growth in Q1 and 3% growth in Q2. In August, retail sales increased 2.1% over the prior year. Online store sales rebounded 1.4% after falling 0.4% in July. Sales at gas stations dropped 1.2%, reflecting lower prices at the pump. However, lower gas prices free up money for other spending.
US industrial production rebounded in August from a Hurricane Beryl-related slide a month earlier, reflecting a pickup in manufacturing and mining output. The 0.8% increase in production at factories, mines and utilities followed a downwardly revised 0.9% decline a month earlier. Manufacturing, which accounts for three-fourths of total industrial production, was boosted by increased motor vehicle output. Excluding auto output, factory production increased 0.3% in August after falling in the prior two months. The Fed’s data showed rebounds in output of consumer goods, business equipment and construction supplies. Meanwhile, capacity utilization at factories, a measure of potential output being used, rose to 77.2% from 76.6%.
There have been some cracks in the economy forming, including credit card delinquencies rising and consumer stress from higher overall price levels. Home and auto affordability will remain an issue. Also, unemployment has risen from 3.7% in January to 4.2% recently. Unemployment is expected to increase to 4.4% by year end and flatten out next year, per the Fed’s latest projections. With an election approaching, changes to fiscal spending, tax rates and regulations could throw a wrench into these best laid plans.
If you build it, they will come
Construction of new homes rose 9.6% in August as builders ramped up new projects. Housing starts rose to a 1.36 million annual pace from 1.24 million in July. Builders in August were still dealing with elevated financing costs to build, though falling mortgage rates may have boosted demand already. Single-family starts surged by 15.8% in August, while apartment starts fell by 6.7%. Building permits, a signal of future construction, rose 4.9% to a 1.48 million rate. Permits for single-family homes rose by 2.8%, and multi-family by 8.4%.
The average interest rate for 30-year fixed-rate mortgages decreased to 6.15%. That is the lowest rate since September 2022 when rates exceeded 7% Total mortgage application volume rose 14.2% last week compared with the previous week, according to the Mortgage Bankers Association. Applications to refinance a home loan jumped 24% from the previous week and were 127% higher than the same week one year ago. Applications for a mortgage to purchase a home increased 5% for the week but were still 0.4% lower than the same week one year ago. As it took time for previous interest rate hikes to slow inflation, it will take time for lower rates to ripple through the economy in a positive way for mortgages, auto loans and credit card balances.
What happens to the stock market after the Federal Reserve begins cutting interest rates? It depends on a number of factors. The last three initial cuts after a hiking cycle preceded bear markets. Before that, there was no discernible difference in returns based on how far the S&P 500 was from a multiyear high before the first cut. An easing cycle can be a positive backdrop for stocks and other risky assets if rate cuts are seen heading off an economic decline. However, if the Fed is seen as behind the curve, investors can get jumpy.
The implications for stocks are mixed. Over the past six easing cycles since 1989, there were only two episodes (1995 and 1998) where the Fed managed to avoid an immediate economic downturn. This time, US equity and bond markets are anticipating that the Fed will achieve a 1995-style soft landing. Previous Fed Chairman Greenspan cut rates to 5.25% from 6% in only six months, sustaining economic growth without reigniting inflation. Alan Greenspan worried about irrational exuberance in markets. Chairman Powell is targeting what we hope is a less slippery slope.
Jimmy Fallon turns 50 years old today, Jeremy Irons turns 76 and Twiggy turns 75.
Christopher Crooks, CFA®, CFP® 610-260-2219