The Federal Reserve has expressed all but certainty that it will cut the federal funds rate at its September 18, 2024, meeting.
I had said before that the Fed could use its July 2024 meeting to tee up an interest-rate cut for its September meeting and affirm that cut at the Jackson Hole Symposium. And, boy, did they ever. Fed Chairman Jay Powell said, “We do not seek or welcome further cooling in labor-market conditions … The time has come for policy to adjust.”
By how much will the Fed cut rates?
The federal funds rate is currently set between 5.25 percent and 5.0 percent. According to the Fed’s Summary of Economic Projections, the Federal Funds interest rate should move to 4.1 percent by the end of 2025. The CME FedWatch tool also shows a 91 percent probability of rates being cut to at least roughly that 4.1 percent level by the end of 2025. Most of the probability weighting, about 80 percent, expresses that the rate will be less than 3.5 percent at the end of 2025.
But what about the rest of this year? The CME FedWatch tool assigns a 100 percent probability of rates being cut by three-quarters of one percentage point this year. That equates to one quarter-percentage-point cut at each of the Fed’s three remaining meetings in 2024. That seems aggressive but not outlandish, given that high short-term rates have yielded more than long-term rates for an extended period.
Based on the rates of the 10-year Treasury note and the three-month Treasury bill, the yield curve has been inverted for 20 months, since October 2022. What does that mean? Typically, long-term debts with similar risk profiles yield more than short-term debts because of the risk premium over time. However, for those 20 months, short-term rates have been higher than long-term rates.
Is 20 months a long time for a yield-curve inversion? It is the lengthiest inversion recorded since 1954. Historically, an inversion has been an excellent predictor of an upcoming recession. There has been much debate about whether a yield-curve inversion causes a recession. Or if the inversion is a sign that other things are going on. Or maybe it is just a coincidence. A common argument is that excessively high Federal Funds rates, which determine three-month Treasury yields, cause recessions. The 10-year yield loosely approximates the best guess of a neutral rate of interest, which is the theoretical federal funds rate at which the monetary policy is neither accommodative nor restrictive. When the Fed keeps the federal funds rate above those levels, the U.S. economy contracts.
It is worth noting that trying to identify a link between a yield-curve inversion and a recession seems to be searching for a narrative that might not exist. For example, there were inversions in 1990, 2001, 2007, and 2020. There were also recessions in those years. In each case, there were clear exogenous shocks associated with the recessions that occurred then: an oil price shock, the dot-com bubble bursting, the financial crisis, and the pandemic.
Another way to look at it is that when the yield curve is inverted, the economy is fragile enough not to withstand a shock. If a recession were to start now, the story would be that inflation was the shock.
I have argued that there is a 40 percent chance of a recession starting in the first half of 2025. A big part of that increased probability of a recession is that the economy is affected by higher interest rates with long and variable lags. The broader economy has yet to feel the effects of higher rates thus far, but it might.
Still, I am not going to get out of the stock market because of this inverted yield curve. What if I got out of the market after 10 months of inversion, halfway through where we are now? Stocks have been performing well; I would have lost out on more stock market gains than I would have been comfortable with.
The markets have rebounded swiftly from their crazy sell-off in early August. As a result, according to the American Association of Individual Investors (AAII) survey, investor bullishness has approached its one-year high and bearishness is well below its historical average. The investor crowd seems rather comfortable, which is a contrarian sign that the stock market is, at best, short-term overbought and needs some of the excesses to be wrung out of it. Combine that with the fact that there are only 70-ish days left until the presidential election. There will be a lot of uncertainty injected into the economy and the stock market over the next couple of months as voters determine who will control fiscal policy for the next four years. The stock market will probably float back down between its 50-day and 200-day moving average, which would mean a pullback of four percent to nine percent.
The S&P 500 has pulled back six percent twice, seven percent, and nine percent in the last 12 months. Other than the last one, which was only a few weeks ago, I reckon that most people have forgotten about those. The point is, I am not worried about any pre-election pullback, especially if the Fed will juice the economy with rate cuts.
How does the stock market perform after the Fed cuts interest rates?
Since 1990, the average returns of the S&P 500, Nasdaq, and Russell 2000 have been higher one, three, and 12 months after the first rate cut of a monetary loosening cycle.
While the average returns are positive, it is worth noting that all periods had winners. And, sometimes, there were divergences. For instance, in 2001, even as the Fed was lowering rates, stocks still faced the backdrop of weakening fundamentals, the 9/11 terror attacks, and the second Gulf War. Given those considerations, it is no surprise that the S&P 500 and Nasdaq were down one year after the first rate cut by -9.6 percent and -10.3 percent, respectively. However, the Russell 2000 small-cap index was up 7.7 percent, reflecting that much of the pain in its larger-cap counterparts was rooted in excessive equity valuations.
In 2019, the Russell 2000 declined due to a yield-curve inversion. During that period, the Nasdaq’s returns left the S&P 500 in the dust as investors rushed into stay-at-home technology stocks, which became favorable as households sheltered at home during the pandemic.
Despite the Fed’s actions, history shows that we should expect other catalysts to either act as support or derail the current stock market rally. Interest rates alone cannot protect the economy from unforeseen economic or political shocks.
Explaining the disappearance of nearly 1 million jobs
(Public Service Announcement: I tried to make this next part as un-nerdy as possible, but there are nerd tracks all over it. If you are not a financial advisor or an economist, you might want to scroll to the last couple of paragraphs.)
A lot fewer jobs were created in the previous year than initially calculated. The Bureau of Labor Statistics (BLS) revised payroll employment for the 12 months ending March 2024. They do that once per year, using hard data from employment insurance filings to improve estimates of the actual number of workers employed as of that March. The result is called the Employment Situation Report. (This is technically the second revision, as monthly revisions are routinely made. This latest update will be revised again later.)
Wide swings of three and four hundred thousand jobs in either direction have not been uncommon. The benchmark revision ending March 2024 was down 818,000, double even those wide swings.
The dramatic shift lower in payrolls from previous years was due, in part, to the surge in business formation. The tool used to estimate the number of company formations and closures is called the Birth-Death Model. One-third of the BLS monthly employment report comes from the Current Employment Statistics (CES) survey. Respondents to the CES survey come from a sample of existing businesses. That sample shrinks over time as some companies close, but the newly formed businesses are not surveyed. The net birth-death adjustment accounts for this tracking error in the monthly number. This year, many new businesses that opened were one-person shops formed by former-wage-earning workers who decided to branch out on their own (as opposed to being a multi-employee business). Also, payroll figures were off due to the surge in immigrant workers who did not find their way into employment insurance reporting. In both instances, post-pandemic labor dynamics were not accounted for.
(End of nerdy stuff.)
No matter the reason, the revisions mean that the economy created about 178,000 jobs per month over that period, as opposed to the previous estimate of 246,000 jobs a month.
Bulls will point out that this is ancient history.
Bears will argue that it is a sign of underlying labor-market weakness.
They are both right. The estimates of the revisions were known months ago, so they have been priced into the stock market. However, weaker job creation is a headwind to economic growth and associated market advances. I am not currently making any investment adjustments because of the revision. However, they could cause me to become defensive more quickly in the months ahead, unless the Fed uses this data as the cover it needs to cut interest rates more deeply and quickly. If the Fed cuts rates fast enough, the U.S. will likely avoid a recession next year.
Investing is complicated; I will keep watching the data to help you make sense of it. And if we cannot understand it, we can, at least, try to react to it in a manner that protects us from running out of money in retirement.
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.
