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The Fed officially put an end to its restrictive monetary policy by cutting interest rates for the first time since March of 2020. That was back deep in the heart of Covid. After a strong recovery for the Economy and asset prices, America’s central bank launched a hiking campaign, raising rates 11 times, starting in the Spring of 2022. They took the overnight rate from zero to 5%+. That’s where they stayed for 14 months, designed to choke off the multi-decade high inflation that sprung. The Fed has now declared victory.
How big of a cut? It was a coin flip going in, whether the Fed would cut by a 1/4-point or 1/2-point. Mystery solved on Wednesday; 1/2-point it was. The fact is, the difference is negligible near term. It’s still an incremental move. But often times, there’s a stall in economic activity after the first cut because people anticipate even lower rates before they act.
Simply put, interest rates are the price of money. It’s what it costs to borrow for big items like cars, houses and appliances. After this cut, borrowers will pay less on their debt. Savers will receive less on their cash.
Interest rates hit multi-decade highs for we Americans. As inflation has eaten away at pricing power, consumers have leveraged credit cards to cover expenses. The problem, there’s now well over $1 Trillion in credit card debt. That translates to an average of $6K per household. Borrowing with a credit card is both easy and costly. Interest rates on credit cards average 21%. It’s a crusher. Lower rates will help, but it’s still dangerously high.
Recalibration was the word of the week. Fed Chair Powell used it a dozen times to describe the central bank’s new approach. Lower for longer is the theme. It’s a complete reversal from the previous approach. The Fed just reopened the money tap. It will take time for the flow to make an impact in the Economy. But the impact was immediate on the Market. Stocks instantly jumped at the surprise cut. Wednesday was a volatile session which ended the day lower. But, the following day brought an explosive rally after sleeping on the news.
Interest rate moves from the Fed tend to have a long and variable lag. Famed economist Milton Friedman said, “there is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable”. Put another way, Friedman joked it’s an economist’s way of saying they have no idea when it works.
Bonds stayed firm as they had already priced such a cut in. In fact, curiously, yields actually rose in the belly of the curve while the Fed cut upfront. Commodities exploded higher. Crypto too. It was risk-on. Perhaps most interesting was the Dollar. It fell. Importantly, the Dollar weakness could trigger a commodity price recovery which could stoke inflation again. When the Dollar goes down, things priced in Dollars tend to go up.
Usually, the Fed starts cutting rates as an emergency measure to cushion against a recession. That’s not the case currently. Well, at least the perception. But make no mistake, the Economy is slowing. The Fed just raised its estimate for unemployment to 4.4% by year-end.
The Stock Market and Bond Market have increasingly shown disagreement on economic outlook. The Bond Market still thinks the landing will be hard. The Stock Market clearly thinks soft. The Fed has provided aggressive support to stocks going back to the Financial Crisis. It’s gotten pretty spoiled. We will find out soon if normalization and recalibration means no more Fed safety net.
A soft-landing would avoid a recession. Lower interest rates would stimulate more spending and trigger an economic stabilization. That’s the Fed’s desire. The Bond Market thinks the Fed is too late and the data ahead will reflect America has already slid into recession. Of course, we won’t know until it’s in the rearview mirror.
The 10-Year Treasury yield fell from its 2-decade high level of 5% to a 3.6% low this week. Falling rates generally preclude an economic slowdown. Smart money took action. Companies have seized on the lower yields. Corporate bond issuance has spiked in recent weeks, making 2024 one of the most active years for the Bond Market.
Mortgage rates have fallen too, providing some relief for home buyers. 30-Year mortgages have fallen from 7% to sub 6% since May. Refinances jumped 14% this week, the most since the Fed started the rate hikes.
Interest rates in home loans and auto loans don’t fall nearly as fast. Those are the areas that need it the most. Loans for new cars currently cost an average of 7.1% across the country. Monthly payments are at a record $700 per month. Used cars come with over 11% rates. They’re going to get cheaper. Will it be fast enough to stem the slide of car sales in America? That’s a big question.
According to the Atlanta Fed, the neutral range of interest rates, which would neither stimulate nor restrict economic growth, is currently somewhere between 3.5% and 4.8%. That’s a pretty wide range. We’re at the high end of that range already.
Whether the Fed cut by 1/4 or 1/2 point didn’t really matter. There’s more to go. The Central Bank indicated another ½ point cut by year-end and another 1% next year. The Market is saying there’s a lot more to go.
Retail sales grew by 0.1% in August. That was better than the 0.2% contraction expected. Falling gas prices contributed significantly to lower sales. That’s a good thing because it means more money that consumers can spend elsewhere. There’s not a lot of evidence that’s happening though. E-commerce and health & wellness were the strength. Also good news, sales in July were revised higher.
The Retail Sales report was the last piece of economic data released before the Fed cut rates Wednesday. Despite slowing growth and high prices, the Consumer is still hanging in there. There’s a big risk that energy prices go higher though, particularly with the serious geopolitical activities ongoing. The economic data did not beg for a 50 basis point cut. But Wall Street sure did; And got it.
At this stage of the cycle, growth and recession avoidance is more important for the Market than the magnitude of the easing cycle. The yield curve is no longer inverted, at least at 2s and 10s. That’s Treasury maturities. The Dollar keeps weakening. The Bond Market had been pricing this rate cut in for a while. Yields have fallen. Prices have gone higher.
Stocks sure celebrated the Fed move. The Dow and S&P both hit fresh, all-time highs. There’s nothing Bearish about that. That said, the first rate cut historically has not been Bullish for stocks. The reason is rate cuts generally come in response to already present economic weakness. The ensuing 3 months tend to be choppy, with a downward bias before settling in.
There are some areas that have historically worked though. Both Health Care and Gold have done well when the Fed started cutting rates. On the flip side, Tech and specifically Semiconductors have historically been big losers after the first cut. We’ve been seeing this type of rotative price action already. Interestingly, the opposite occurred on Thursday, though Gold kept soaring higher.
Fed Chair Powell has been adamant all along that politics play zero role in monetary policy. But it didn’t take long for politicians to jump on this move. Naturally, incumbents welcome looser monetary policy moves during an election while the other party calls foul. The next Fed meeting is the day after the election.
Another area that was immediately impacted by Wednesday’s news were Money Market Funds. They had maintained those 5% yields, with very short maturities largely tied to the overnight rate. They’re 5% no longer. But they’re still quite attractive compared to recent history.
The fact is, for 2 decades, Americans got really used to cheap money and low rates. Normalization has been bumpy. We hadn’t had inflation for a long time. Zero-interest loans were pervasive in our society. That is not normal. But many Americans didn’t know any difference. So I guess this new stage is called recalibration. Years later, we are still paying the price for the Financial Crisis and Covid. Whatever it takes comes with a cost. We mustn’t ever forget, there’s no such thing as free.
For more Market chatter, check out our podcast. This week, Quint and I cover the Fed, Energy and beyond. Feel free to like it and tell a friend.
Have a nice weekend. We’ll be back, dark and early on Monday.
Mike
