In late 2023, the consensus expectation was that the Federal Reserve would cut interest rates by one-quarter of one percentage point (aka 25 basis points) six times. I was adamant that that expectation was “absurd.” I argued that the most likely timing of the Fed’s first rate cut in this cycle would occur at their December 2024 meeting.
More recently, I had argued that there was a good chance that the Fed would use their July 2024 meeting to tee up a cut (which they did), reaffirm that stance in August at their Jackson Hole Symposium, and cut in September. The consensus now agrees with me (or vice versa); my baseline scenario is an interest rate cut in September.
The CME FedWatch futures market predicts a 100 percent chance of the Federal Reserve cutting interest rates by one-quarter of one percentage point (aka 25 basis points) or more at its September 18, 2024, meeting. The odds point to a 30 percent chance of a 25-basis-points cut. But, if that doesn’t happen, the Fed would cut even more by 50 basis points (a 70 percent chance). Much of this expectation is due to a weakening labor market—not that the labor market is weak; it is merely normalizing. But when it comes to investing, it is not about good or bad; it is about better or worse.
It is hard to say that the labor market is weak when the unemployment rate is 4.3 percent. Not too long ago, a 4.3 percent unemployment rate was considered to be lower than the natural rate of unemployment. However, there are signs of it cooling.
The latest Job Openings and Labor Turnover Survey (JOLTS) showed the ratio of job openings to unemployed workers was 1.2, the lowest since June 2021. While concerning, it is not yet troubling; it is far from signaling a recession.
If you are interested in the Federal Reserve cutting interest rates, then seeing the ratio of job openings to the number of unemployed workers fall back to pre-pandemic levels is not at all concerning. A cooling labor market gives the Fed a reason to cut interest rates in September. That trend has kept wage growth from overheating, which helps keep inflation in check. Average hourly earnings rose 3.9 percent year over year in June 2024, two percentage points below the post-pandemic high of 5.9 percent in March 2022.
Also, the number of hires as a percentage of the labor market has fallen sharply, down to 3.4 percent, its lowest rate since March 2020. Contrasting job openings as a percentage of the labor force is a good way to compare current conditions with prior cycles, as it adjusts for population growth. What does that mean? Workers looking for new jobs will find fewer opportunities than they had since the economy began to emerge from the brief but deep recession that occurred in March and April of 2020. That, too, is not yet troubling. The Fed wants to get ahead of concerning data before it becomes problematic.
It also gives the Federal Reserve, which constantly reminds us that it is data dependent, the cover it needs to cut rates in September. The job-opening-to-unemployed ratio is back to pre-pandemic levels. And wage growth is trending toward the 2019 range of 3.0 to 3.5 percent. Both data points are consistent with the Fed’s target of two percent for inflation.
Sahm Rule Recession Indicator Triggered
Following the previous payroll report for June 2024, I posted a video on my LinkedIn page explaining that the so-called “Sahm Rule” was close to being triggered. As of the July 2024 payroll report, the unemployment rate increased enough to call the rule into play.
Developed by former Federal Reserve economist Claudia Sahm, the Sahm Rule is a tool for identifying the start of a recession using the total unemployment rate.
Specifically, the rule doesn’t look at the actual unemployment rate but rather at the three-month average, which smooths out anomalies and better tracks trends. The rule compares the three-month average of the unemployment rate to the three-month average of the unemployment rate’s trough. Historically, when that difference is one-half percentage point or more, that has been a sign that a U.S. recession has already begun.
The Sahm Rule Recession Indicator is now above the 0.5 percent mark, at 0.53 percent, arguing that the U.S. economy is undergoing a recession. The chart below from Bank of America shows previous Sahm readings; the only year in which the Sahm Rule was triggered and the economy was not in a recession was 1959. However, a recession did start five months later.
Triggering the Sahm Rule does not mean that the U.S. is definitively in a recession or that one will start soon. After all, the yield curve has been inverted for about two years, and the Conference Board’s leading economic index has been off its peak and trending negative for 29 months. Both metrics would have argued for a recession in 2023 that never came. Even Claudia Sahm doesn’t think we are in a recession right now (she claims that changes in the post-pandemic labor supply and the higher number of immigrant workers have diminished its usefulness). When it comes to investing, being early is the same as being wrong.
In any given year, the natural odds of a recession are about 15 percent (recessions occur on average every seven years). I believe there is a 40 percent chance of a recession starting by March 2025. Those increased odds reflect the normalization of the labor market and the effect of higher interest rates. In a previous “Capital Ideas” column, I explained that high interest rates from the Fed’s rate-hike campaign to fight inflation would impact households and corporations by early 2025. The precise time would remain unknown because the effect of higher interest rates is subjected to long and variable lags.
Recently, market pundits in the media have called for the Fed to make emergency interest rate cuts because they feel we are on the precipice of a recession. Although the risk of a recession is elevated, those claims currently feel more like hyperbole or book-talking than a reflection of data. Gross Domestic Product, a broad measure of the U.S. economy, has been humming along.
GDP Surprise — Why there is no need for an emergency interest rate cut
U.S. GDP grew at an annualized rate of 2.8 percent in the second quarter of 2024. That was well above the forecasts of two percent and compares to the modest gain of 1.4 percent for the first quarter, showing positive momentum.
Even including the previous quarter’s modest growth rate, the average GDP growth rate for the last four quarters is 3.1 percent. While early still, the Atlanta Fed’s GDPNow tool is tracking GDP for the third quarter of 2024 at 2.9 percent. That is not so accelerated that the Fed should raise interest rates, but it is strong enough that the Fed could easily wait until September to make a cut.
Volatility Spike
In another recent video on my LinkedIn page, I said, “The odds of experiencing significant volatility throughout the next few months are high. Historically, August and October are the most volatile months, as measured by spikes in the VIX, also known as the ‘fear index.’” The VIX measures stock market volatility—the higher the VIX, the greater the volatility.
On August 5, 2024, the VIX spiked intraday to 65.73. That has only been higher during the Great Financial Crisis and the COVID-19 market sell-off. The good news is that is a massive buy signal for a contrarian like me. I should be ebullient as other investors are frantic and scared, but I remain nervous. That spike to 65.73 rose from the prior day’s close of 23.39. That jump was too massive to fit into many other historical contexts. Daily stock market gains and losses have been more significant in recent weeks than previous price movements, which is partly why the VIX shot so high. There is a saying that sharp volatility gets resolved sharply. I would not be surprised to see a brief rally in stocks. However, after that, the question will be whether investors should hold their current stock positions or take a more defensive position.
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
