Financial Forum - October 2024
Market Commentary – The Fed Finally Cuts Rates
Stocks ended the third quarter with a much-anticipated, larger-than-expected 0.5% rate cut as the Federal Reserve attempts to keep the economy growing, while simultaneously, hoping that cutting rates won’t cause another rise in inflation. It’s a tough balancing act, but after two-plus years of high rates, the Fed believed that easing would give the U.S. economy its best chance of sustaining growth while protecting the job market. Officials are concerned about the recent uptick in the unemployment rate, and by starting off with a big cut, the Fed is in effect taking out insurance against a bigger employment slowdown. During the press conference, Chairman Powell stated that the board now expects another half-point reduction in rates before the end of the year. While Mr. Powell said that the Fed was not yet ready to declare “mission accomplished” on taming inflation, he added that officials were “encouraged” by the progress that they had seen. So far, Fed officials have managed to slow inflation notably without causing major economic problems. The unemployment rate has crept up, but it hasn’t jumped painfully. Hiring persists, though it has slowed. Consumer spending remains strong and overall growth is still solid. This resilience has made Fed officials hopeful that they might be able to pull off a historically rare “soft landing,” in which they manage to put the economy on a healthy and sustainable track without causing a recession. The bond market received the message as the yield curve un-inverted for the first time in over two years. Will the Fed be successful? Only time will tell, but let’s look at some history.
The Yield Curve Un-Inverts. Has This Historically Been a Good Thing?
When the 2-year Treasury yield trades above the 10-year, it’s a phenomenon known as an inverted yield curve, meaning investors see more economic risk now than farther in the future. That’s because, when risks are elevated, investors will demand a higher payout, or yield, to invest in US Treasury notes. When the yield curve inverts, it historically has meant a recession is looming. So, you would think that investors would have celebrated last month when this warning sign stopped flashing. Let’s look at history for some guidance.
Since 1998, there have been six inversions of the 10s-2s yield spread: June 1998, February 2000, January 2006, June 2006, August 2019, and July 2022. Four of these instances were very brief inversions lasting only about a month. Because the current inversion, which just ended, was over two years old, I don’t think the four short-term inversions will provide us with much insight. However, the inversions of early 2000 and 2006 were much longer and are more analogous to the current inversion. In both prior instances (2000 and 2006), the yield curve un-inverting was a negative signal for stocks. As it turns out, when the yield curve turns positive, or un-inverts, right before the Fed starts cutting interest rates, a recession tends to kick in not long afterward. For instance, when the yield curve turned positive in December 2000, the Fed cut interest rates a month later. Two months after that, a recession began. A similar sequence of events happened in 2006 in the lead-up to the Great Recession. It is important to note, however, that not all yield curve in-inversions have led to recessions.
Why does un-inversions often lead to recessions? When the 10s-2s spread turns back positive, it’s usually because the 2-year Treasury yield is falling quickly as investors price in aggressive rate cuts. Rate cuts usually occur because the Fed is worried about economic growth (which is happening now). However, the Fed is usually too late with their rate cuts, and the economy is already, or soon to be, in a recession. In other words, buckle your seatbelts, turbulence may be ahead.
As We See It:
The burden of proof remains with the bears. Simply put, the news isn’t bad enough yet to cause a sustainable decline in stocks. Yes, there are economic and earnings warning signs, including: a rising unemployment rate, very weak ISM Manufacturing PMI, negative bank guidance, and an uncertain retail environment, to name a few. There are also negative macro risks such as political uncertainty (Trump or Harris?), economic uncertainty (hard vs. soft landing), and geopolitical turmoil (Russia/Ukraine, Israel/Hamas, Taiwan/China). But these potential risks and anecdotal negatives, while all legitimate, are not yet enough to distract investors from the positive factors in this market, which include:
Generally, “ok” economic data (yes, it’s clearly slowing, but as of right now it’s still “ok.”)
An accommodative Fed (Investors often ignore the reality that Fed rate cuts don’t always extend market rallies, so they initially welcome cuts as bullish. That’s why the market just made a new high.)
Earnings that are still expected to grow year-over-year.
AI enthusiasm (it has been reduced, but still alive).
The combination of the above-listed risks and elevated valuations make this market very exposed to:
Negative shocks that could cause a sharp “air pocket” in stocks similar to what we saw in early August, and/or
A growth scare that would easily open up a sustainable and long-lasting decline in stocks.
Bottom Line:
The risks facing this market (economic and earnings growth, geopolitics) are consequential. They will not present themselves all at once - they will evolve over time until they become sustainable, and that’s when bear markets occur. Today’s market is facing those challenges but facing them does not mean they will happen. Closely monitoring these risks is paramount. Rest assured, if and when the facts change, we will do our best to respond accordingly.
Quarterly thought…How to be Truly Rich
“Before you speak, listen. Before you write, think. Before you spend, earn. Before you invest, investigate. Before you criticize, wait. Before you pray, forgive. Before you quit, try. Before you retire, save. Before you die, give.” (William A. Ward)
Practice each of these and you’ll be a rich individual.
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*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
* The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
