The big news this quarter occurred only a couple of weeks ago when after two and a half years, the Federal Reserve finally reversed course and cut the fed funds rate by half a point. This marks the end of the Fed’s battle to rein in the skyrocketing inflation that we saw from late 2021 through early 2023. The question now is how aggressively will they lower rates from here?
The stock market has been betting on rate cuts since the beginning of the year and this optimism has largely been responsible for the gains we’ve seen so far. Now that the change in policy is here, the next guess is how low and at what pace the Fed will go. They have emphatically stated that the answer to those questions will depend on the economic data that is released throughout the coming months. The most important information they’ll likely be focusing on is employment, inflation and GDP. We do think the Fed’s bias strongly favors lowering rates. So, if the inflation data remains in check, the Fed will likely continue to lower rates a quarter point at a time every few months through the first half of next year. If this scenario plays out, we should see further gains in the U.S. stock market into the middle of next year.
That being said, one has to wonder if the market is pricing in too many cuts. Money market futures imply there is a one-in-three chance the Fed will deliver another half-point cut in November and are pricing a total of about 190 basis points of easing by the end of next year. Honestly, it’s hard to see that materializing.
One interesting aspect of these rate increases is that longer-term rates haven’t moved in lockstep with the fed funds rate change. While the 5-30 year treasury yields are down from their peaks a year ago, the 10 year treasury yield is actually higher since the half point Fed rate cut. This is because the Fed is only able to directly set short-term rates, while long-term rates are market driven.
Stock returns and the normalization of interest rates suggest the economy is on sound footing, but there are several significant events that could derail this scenario over the coming months. The most obvious is the Federal elections next month. Most of the news has been focused on the presidential election, but the reality is that the house and senate races are probably as or more relevant to the economy. If the government remains divided between the two parties, it’s unlikely that any meaningful tax or spending legislation will be passed. Generally speaking, this is a good thing. While there certainly are a lot of things that need to be addressed, a legislative stalemate means at least they won’t make things worse.
The other two potential market moving hot spots are the conflicts in the Middle East and Ukraine. The Israeli offensive has now spread outside their borders to Lebanon and now Iran. In addition to the human toll this is taking, oil prices are inching up as more of that region is getting involved in the conflict. It’s no surprise that higher oil prices lead to higher inflation and thus could put the Fed’s plans on hold.
