When doves yell: Fed loudly signals a September rate cut

Last week saw an abundance of dovishness from the US Federal Reserve (Fed), which only increased expectations for a September interest rate cut. First, we got the minutes from July’s Federal Open Market Committee (FOMC) meeting, which were surprisingly dovish. And then, during his long-awaited speech at Jackson Hole, Fed Chair Jay Powell indicated that a policy shift is imminent. Given these developments, I can’t help but think about a certain song about doves, but in my version, they’re yelling instead of crying (if you’d like to get the same song stuck in your head also, I’ll share my lyrics at the end.)

The FOMC says a September rate cut is likely appropriate

The minutes from the July FOMC meeting were surprisingly dovish;¹ participants recognized that the US has made more compelling disinflationary progress. More importantly, there was a focus on downside risks, especially a weakening labour market and fears of a more serious deterioration – and July’s meeting of course came well before the August release of the preliminary annual review of jobs, which showed a serious downward revision to jobs created.

While “several” participants noted that easing monetary policy too soon could risk a resurgence in inflation, “many” participants noted that easing policy too little or too late “could risk unduly weakening economic activity or employment.”

It seems clear the Fed no longer sees risks as balanced: “A majority of participants remarked that the risks to the employment goal had increased, and many participants noted that the risks to the inflation goal had decreased…Some participants noted the risk that a further gradual easing in labor market conditions could transition to a more serious deterioration.”

It's also important to note that the staff’s economic forecast for the July FOMC meeting was “marked down largely in response to weaker-than-expected labor market indicators.” Most importantly, we learned that a “vast majority” of participants said “it would likely be appropriate to ease policy at the next meeting” if the economy evolved as the Committee expected.

Powell says now’s the time for Fed policy to adjust

Then came Powell’s long-awaited speech from the Kansas City Fed’s Symposium at Jackson Hole. Powell was more dovish than I expected, even after reading the July FOMC meeting minutes. In my view, Powell said all the right things and signaled a policy shift is imminent: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” He also shared the powerful statement, “We do not seek or welcome further cooling in labor market conditions.” 

Powell didn’t even use the term “gradual” to describe his expectations around rate cuts. Not surprisingly, markets reacted positively, with small caps and cyclicals outperforming.²

The last time the Fed hiked rates was July 26, 2023. If a September rate cut comes to fruition, that means there will be about 14 months between the last rate hike and the first rate cut, which is significantly longer than the average time frame between the end of tightening and the start of easing (the average time from last rate hike to first rate cut in the last four policy cycles was 9 months).³

Markets are closely watching the economic data

Stocks have been waiting a long time for this moment. We have had several periods in the last year in which small caps and cyclicals briefly outperformed, but they were never sustainable. However, this time I believe such outperformance could be sustainable – as long as new economic data doesn’t reignite concerns about recession.

A soft landing is still my base case scenario for the US economy, but recession risks continue to rise every day that monetary policy is this restrictive. From now until the September FOMC meeting, we should be watching economic data closely for signs of further weakening since the risk of recession is the biggest risk facing the economy right now. In past months, bad news about the economy was seen as good news for stocks, as it upped the chances for a Fed rate cut. But now, it’s likely that bad news would simply be seen as bad news. Worse-than-expected economic data could especially derail any small cap or cyclical rally.

And that brings me back to singing about doves:

“Dig if you will the picture
Of a US soft landing bliss
Target inflation is near
Can you my darling
can you picture this?

The threat of recession worries me
Job losses at risk
Makes me lose sleep
Can we my darling
Can we avoid this?

How can we just leave the economy standing
With monetary policy that's so cold? (So cold)
Maybe this Fed’s just too demanding
Maybe they’re just like Paul Volcker, too bold

In September they’ll start easing
Rates are too high
It’s time to shift policy
They don’t want to hear what it sounds like
When doves cry”

Apologies to those who are wincing right now – there is a reason I never became a songwriter.

Looking ahead

This week, the focus will be on Nvidia earnings and the Personal Consumption Expenditures (PCE) print for the US. I would caution against placing too much emphasis on Nvidia earnings since we are seeing contributions to earnings growth coming from more companies in the S&P 500, which means Nvidia’s earnings are becoming less important. The PCE print will be most important, although I can’t imagine a print that would derail the Fed’s intent to cut in September.