After one of the biggest and fastest rate hike cycles in history, the Federal Reserve is all set to begin the unwinding of restrictive monetary policy of the past two years. Investors are pricing in a near certainty that we get our first rate cut tomorrow at the conclusion of the Central Bank’s September meeting. The big question is whether it will be 25 or 50 bps. The market is evenly divided on that issue. The talking heads all have opinions as to which is best and the impact on stocks immediately following the announcement. I won’t add another opinion here but will suggest that what really matters most is that we are at a critical juncture, and that we are now going to see policy (e.g. interest rates) help asset prices rather than hold them back. This coming “rate cutting cycle” will be the 13th since 1965.
So, what should we expect over the next year as this unfolds? Before I answer that, let’s review why the Fed raises and cuts rates in the first place. The Fed raises rates to slow the economy – and particularly consumer spending. This is the demand side of things. When demand gets out of balance with supply, we get inflation. Throw in a few trillion dollars’ worth of printed money and you get even more inflation. This is what happened during the pandemic and coming out the other side of it. The Fed raised rates as fast as possible to curtail inflation that was raging all around our economy. The Fed lowers interest rates when it wants to stimulate demand in the face of a slowing economy. It does this to make sure we don’t fall into a recession and workers begin losing their jobs, which further reduces demand. In this way, rising rates are the brakes on the car and falling rates are the gas pedal. The Federal Reserve has only two jobs, but they can be contradictory. The first is to keep inflation low and pegged to its 2% target. The second is to maximize employment. They decide which of these mandates is most at risk at any given time and direct their interest rate response accordingly. Since the pandemic ended, it has been fighting inflation. Now that inflation is deemed to be in check it is fighting unemployment, which is still low but rising. This balancing act is what results in interest rate policy changing periodically. Most of the time, the Fed is late to respond because the economy is huge and lumbering. It has a lot of inertia and by the time the problem shows up in the data it is too late. It is like trying to stop a train. It takes a while to stop a train and often by the time you realize it needs to stop it is just too late to prevent the damage. This is why the majority of rate hiking cycles end in recession. By the time the Fed reverses course and begins to get its foot off the brake, the train has already slowed to such an extent that it takes a whole lot of gas (and time) to get it moving again up to speed.
Right now, the data shows a weakening economy, lower inflation and rising unemployment. The economy is still growing, but more slowly, unemployment is still low but rising. In sum, we don’t see the recession yet and it is everyone’s goal to keep the train moving so that it doesn’t slow anymore. This looks possible despite all the experts who said otherwise over the past two years. I wrote a commentary back in 2022 that suggested the Fed would have to thread a needle to get this done and it appears it may have done it.
Here is what history says happens when the Fed begins a rate cutting cycle (according to a Lincoln Financial Newsletter sent on Monday, September 16, 2024):
- Since 1965 we have had 12 rate cutting cycles.
- Overall, in the 12 months after the start of cutting rates, stocks have gone up an average of +5%.
- The majority of those cycles accompanied a recession. When a recession was involved the 12-month return was -3%.
- When a recession did not occur the 12-month return was +18%.
- With or without a recession, government and corporate grade bonds do well as they benefit from falling interest rates.
- If you have a balanced portfolio, you should be optimistic about next year. If we avoid a recession, you should be very optimistic.
The past four years have been unprecedented in so many ways that it is hard to firmly take a position on almost anything. With that said, I am in the very optimistic camp.
At Cabana, we remain in our “bullish scene” and are allocated accordingly.
