Key Takeaways from the Fed’s Supersized Rate Cut
• A Critical Turning Point: The Fed’s larger-than-usual 0.5% rate cut signals a significant shift in monetary policy, transitioning from aggressive tightening to an easing cycle. This proactive move aims to support the labor market and ensure continued economic expansion, increasing the likelihood of a “soft landing.”
• Not a One-Time Event: The Fed’s rate cut marks the beginning of a multi-year easing cycle with a goal of reaching a neutral interest rate by 2026. This gradual reduction in borrowing costs should benefit consumers and businesses, potentially leading to economic reacceleration. While the Fed doesn’t set long-term rates, the 30-year mortgage rate has declined toward 6% after the Fed’s Sept. 18 rate cut. That’s down from similar mortgage rates approaching 8% in November 2023. Last week, applications to refinance home loans surged 20% as compared to the previous week, while purchase applications only improved by 1%. This will undoubtedly provide increased spending power for the economy, assuming that it doesn’t all go into savings.
• Positive for Stocks, If No Recession: Historically, the start of a rate-cutting cycle without a recession has been favorable for stocks. An analysis of the last 10 rate cutting cycles shows that the average return for the S&P 500 is approximately 15% in the one-year period following the Fed’s first rate cut. However, if a recession followed the first rate cut, which occurred on three occasions, the average return was -8%.
Fed’s Aggressive Rate Cut Sparks Inflation Fears in Bond Market
The Federal Reserve’s decision to initiate an aggressive easing cycle by implementing a 50-bps interest rate cut has raised concerns about a potential resurgence of inflation in the U.S. bond market. Investors worry that the resulting looser financial conditions could reignite price pressures, especially given the Fed’s shift in focus toward protecting the job market. The Fed controls short-term rates, but investors set long-term interest rates. Yields on longer-dated Treasuries, which are highly sensitive to inflation expectations, have increased from 3.6% to 3.8% following the Fed’s move, reflecting investor worries. This shift has prompted questions about how quickly inflation will decline to the Fed’s target in an environment of lower interest rates.
Some analysts suggest that the Fed’s substantial rate cut, referred to as the “Powell put,” might have been premature considering the current economic resilience and strong stock market performance. In fact, the stock market is up nearly 20% this year and is on pace to posting two consecutive years of double-digit gains.
The Fed’s emphasis on economic strength has led to concerns that the path to lower interest rates may be gradual and uneven. The Fed’s own forecasts on interest rates also suggest a slower pace of cuts than the market had anticipated. And, expectations for inflation over the next decade have increased after the Fed’s announcement, with the 10-year breakeven inflation rate reaching its highest point since early August.
The Pace and Magnitude of Future Fed Rate Cuts Matter
While inflation has significantly decreased over the past two years, it remains above the Fed’s 2% target, and recent monthly data indicates some persistence in price pressures. This has fueled doubts about whether the Fed’s aggressive rate cut was warranted. Some officials, like Fed Governor Michelle Bowman, have expressed concerns that the move could be perceived as a premature declaration of victory against inflation.
An aggressive easing cycle by the Fed could make achieving the 2% inflation target more challenging. An easing cycle combined with expanding federal budget deficits, which is the likely outcome regardless of who wins the upcoming presidential election, could further inhibit the path towards a 2% inflation rate. The situation underscores the delicate balance the Fed must maintain between supporting economic growth and managing inflation risks.
At 21-22x next year’s earnings, the S&P 500 valuation reflects optimistic earnings growth expectations for companies. If long-term interest rates increase because inflation reignites, it will be difficult to justify a higher earnings multiple for stocks. This doesn’t mean stocks can’t go up, but it does suggest being selective about opportunities rather than chasing stocks that have inflated valuations. Time will tell whether the Fed can land the plane softly or if a bumpy landing is in store.
Actress Linda Hamilton (Terminator) turns 68 today, tennis great Serena Williams turns 43, and former Congressman Beto O’Rourke is 52.
Christopher Gildea 610-260-2235