This past quarter saw notable changes in the financial landscape that could have a meaningful impact on the economy and the market going forward. The Federal Reserve (Fed) has taken steps to lower interest rates, which means borrowing costs for things like mortgages, car loans, and credit cards should decrease. This move is often intended to stimulate economic activity by making it easier for consumers and businesses to spend and invest. In addition, the yield curve, which had been inverted for a while, is now beginning to return to its normal shape. Typically, an inverted yield curve (where short-term interest rates are higher than long-term ones) signals uncertainty about future economic growth, can be seen as a warning sign, and has historically been a signal that a recession lies ahead. However, as the yield curve normalizes, it indicates growing confidence in the long-term outlook for the economy, suggesting we may be entering a more stable and positive phase. These developments bring both pros, such as potentially more affordable borrowing and increased economic optimism, and cons, like the possibility of lower returns on savings or the risk of inflation rising in response to lower interest rates.
After nearly 14 months of the Fed in a holding pattern and rates in restrictive territory, they implemented their first cut of the cycle. The last rate hike was announced on July 26, 2023, and the Fed has been on hold since that time. On the day of the Fed’s announcement, the stock market initially took the news as positive, and the Dow Jones jumped 300 points. When Chair Powell started his press conference, volatility spiked, causing the Dow to drop 300 points. The whipsaw action persisted throughout the event and the trading day, resulting in fluctuations of nearly 2,500 points before the Dow closed nearly flat. The market opened higher the next morning and has continued to rise since. And for the first time in 5 years, September was a positive month for the S&P 500.
The chart below illustrates how restrictive rates are, despite the recent 0.50% rate cut. PCE (Personal Consumption Expenditures), which is the Fed’s preferred measure of inflation, has been steadily declining since the summer of 2022 and is nearly back to the 2% target they seek, as is CPI (Consumer Price Index). The Fed Funds Rate presently stands at 4.75% to 5.00%. This approximate 2.5% variance between these two figures illustrates just how restrictive the Fed still is.
The S&P 500 has generally performed well after the first rate cut, but understanding the catalyst behind the cut and future easing is crucial. In the chart below, Goldman Sachs identifies three key reasons for the Fed's rate reductions throughout history:
1. Growth Scare: This occurs when investors fear an economic slowdown, often triggered by negative news like declining job creation or reduced consumer and business spending. As a result, investors typically sell stocks and shift to safer investments due to uncertainty about the economy's direction.
2. Recession: This refers to a significant economic slowdown, officially determined by the National Bureau of Economic Research (NBER). A common early indicator is two consecutive quarters of negative GDP, but the NBER provides the official announcement on the business cycle.
3. Normalization: This encompasses the routine adjustment of interest rates in response to changing economic conditions.
The rationale for the rate cut is the key to the Fed’s “soft landing” talk, or lowering rates so as not to end up in a recession. And the rate cut the Fed just announced presently fits in the normalization definition. The Fed began their tightening cycle to slow inflation; they paused once they felt they were in restrictive territory, and now that there are visible signs that inflation is cooling, they have begun the next phase, lowering rates. One important distinction to note: inflation cooling and prices going down are two different things. The monthly inflation economic data releases are simply measuring how much prices for goods and services bought by consumers or producers have increased or decreased compared to the previous month. If PCE continues to move towards the Fed’s 2% target, that still means that prices are increasing, albeit at a reasonable pace. It does not mean that consumers will see prices come down, which seems to be a common misconception. The chart below utilizes the Consumer Price Index (CPI) to illustrate how extreme the pace of inflation was. The chart highlights that if CPI inflation maintained its 2% long-term average, consumers would have experienced a total of 9% inflation from 2020 to current. The reality is that consumers faced inflation at 21% instead.
Why did the Fed and Chair Powell move aggressively with a 50-basis point cut for their first cut? As a reminder, the Fed has a dual mandate:
1. Price Stability: Keep inflation low and stable, with a long-term target for inflation of around 2%. By keeping prices predictable, the Fed helps maintain the purchasing power of money and reduces uncertainty in the economy.
2. Maximum Employment: They aim to achieve the highest possible level of employment, meaning as many people as possible are working without causing inflation to rise. This doesn't mean zero unemployment but rather a level that aligns with a healthy, growing economy.
In a recent note following the Fed meeting, JPMorgan indicated that the slowdown in the job market now poses a greater risk to the economy than inflation. It appears the Fed is shifting its focus toward supporting employment, especially since job growth is slowing down while inflation is already close to their target level. In Chair Powell’s annual Jackson Hole speech, he is quoted as saying, “Nominal wage gains have moderated. All told, labor market conditions are now less tight than just before the pandemic in 2019 - a year when inflation ran below 2 percent. It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions.” This speech was delivered nearly a month before the first cut.
There is good reason to keep a close eye on the labor market, as job weakness could derail the soft landing the Fed is working to engineer. Continued cooling could adversely impact consumer spending, business investment, income and wages, economic confidence, and tax revenues. This is likely the reason the Chair Powell stated that he does not want to see further deterioration of the labor market as it could lead to a recession scare.
A US recession is presently not the base case expectation for the US economy in the next 12 months. Below is a slide that Goldman Sachs created that highlights the probability of a recession in the next 12 months. They currently place a 20% probability of a recession in the next 12 months at 20%, which is less than the 30% probability as forecasted by all the economists that Bloomberg surveyed. Using either figure, a recession is not the base case, and we should see further easing aligning with a normalized cut in rates over time.
The yield curve, as measured by the 2-year vs. 10-year Treasury note, finally returned to normal. Meaning it is no longer inverted. However, the 3-month T-Bill to 10-year Treasury remains inverted. The inversion began in July 2022 and has lasted a little more than 2 years. Historically, yield curve inversion has been a precursor to a recession, specifically when it reverts to normal. In fact, the normalization of the 10-year to 3-month has correctly predicted the last seven recessions. Note that the recession usually takes place after the rate curve normalizes. However, a recession does not appear to be on the horizon, based on the current forecasts of US economists.
The first rate cut of each easing cycle has also been a bullish sign for the S&P 500, especially in circumstances where a recessionary is not present. As the chart below shows, since 1974 the S&P 500 has been higher in the one- and two-year periods following the first rate cut by 19% and 52%, respectively. Note that in recessionary circumstances the market is still higher but lags the former figures significantly.
As we look ahead to November 5th , it’s clear that the upcoming election will likely bring a period of heightened uncertainty in the markets. Historically, elections can lead to increased volatility as investors react to shifts in policy expectations and potential changes in government leadership. It’s important to remember that markets tend to be forward-looking and often react before the final outcomes are known. The chart below highlights the pre- and post-election performance of the S&P 500 around the presidential election since 1948.
During times like these, staying focused on your long-term investment strategy is crucial. Short-term fluctuations are a normal part of investing, especially during politically sensitive periods. I will continue to monitor the developments closely. If you have any questions or concerns, please don't hesitate to reach out. Thank you for your continued trust, and I will keep you updated as the situation evolves.
If you are not presently a client and would like to discuss your personal circumstances, please do not hesitate to reach out to me.
Feel free to schedule a quick 15-minute virtual introduction meeting.
Rob Leiphart, CFP®
203-220-6474
rleiphart@rbcapitalmanagement.com