Above the Noise: Countdown to a rate cut

Dark Helmet: When will then be now?

Colonel Sandurz: Soon.

Dark Helmet: How soon?

As the market assesses the timing of the first Federal Reserve (Fed) rate cut, I began this month’s article with the movie Spaceballs and the genius of Mel Brooks. After a year of asking “when will then be now,” the policy clarity that investors have desired appears to be forming. The first interest rate cut is expected soon. How soon? The implied rate suggests that the first cut may be coming in September.¹ Inflation has significantly moderated,² and US growth is clearly slowing.³ If the Fed is paying attention, then it’s likely that “then” will be now soon.

It may be confirmation bias but…

…value and smaller-capitalization stocks have tended to outperform growth and mega-cap stocks as the yield curve has normalized.⁴ The difference between the 10-year and 2-year US Treasury rates troughed at -1.08% one year ago and narrowed to 0.22% by mid-July as the market priced in future rate cuts.⁵  With multiple rate cuts potentially to come over the next year, the much-anticipated broadening of markets may be in its early stages. 

Since you asked (part 1)

Q: What would indicate that a recession is imminent?

First, there would be signs of significant leverage and excess in the economy. There isn’t. The annual change in business borrowing is essentially flat.⁶ Also, the challenge for the economy hasn’t been cyclical excess but rather not enough business inventories⁷ and homes,⁸ to name a few.

Second, survey data would be plunging. It isn’t. For example, consumer sentiment bottomed in June 2022 and is above past recession levels.⁹ In addition, the Institute for Supply Management’s survey of purchasing managers in the manufacturing sector bottomed over a year ago and has been hovering between signaling expansion and contraction but remains well above recession-level troughs.¹⁰

Finally, the corporate bond spreads, which tend to be the “canary in the coal mine,” would be widening. They aren’t. Borrowing costs for US businesses remain significantly below the long-term average and levels reached ahead of past recessions.¹¹ (Coal miners no longer use canaries to detect toxic gases, if anyone is wondering.)

Since you asked (part 2)

Q: Is the recent rise in interest rates concerning? Have the bond vigilantes returned? Could this be a  “Liz Truss moment” for the US? (July 1, 2024)

A: The date I received the question is provided because the 10-year US Treasury rate has declined since then. The question is still worth answering, though, because it will come up again. First, some definitions:

A bond vigilante is a bond market investor who sells bonds to protect against government policies that they believe are inflationary or expansionary.

The “Liz Truss moment refers to the poorly received fiscal plans of the UK prime minister, which brought the UK bond market to the brink of disaster and resulted in her ouster.

No, the rise in interest rates in late June/early July wasn't “the Liz Truss moment” nor the return of the bond vigilantes. Risk assets performed well during that period,¹² and the US dollar was strong.¹³ There’s little reason to believe that US Treasury rates are trading on anything else but the nominal growth potential of the US economy. Cyclically, with the US economy slowing and inflation moderating, rates are more likely to fall than to concern themselves in the near term with the fiscal plans of the next US administration.

It was said

“Now that inflation has come down and the labor market has indeed cooled off, we’re going to be looking at both mandates. They’re in much better balance.”

– Fed Chair Jerome Powell

Better late than never! The mandates are in better balance, but the balance of risk now skews to the growth side. The time has come to stop fighting the inflation war and instead focus on shoring up employment as modest cracks are emerging.

It's that time again?

I’m consistently perplexed by the idea that one party or the other is better for markets. I’ve tried to fight the battle but appear to be losing. My inbox is inundated with notes “helping” me to trade based on Donald Trump’s improving odds to win the presidency. I’m being told the Trump trade is long crypto and European defense stocks and short Chinese stocks. It’s almost as if bitcoin prices and European defense stocks didn’t double and Chinese stocks didn’t decline under the first 3.5 years of Joe Biden’s term.¹⁴

For those keeping score, the S&P 500 Index was up 70.2% from the day Donald Trump was elected until the day Joe Biden and Kamala Harris were elected. Since then, it’s up 76.4%.¹⁵ Growth outperformed value under Trump. Growth outperformed value under Biden and Harris.¹⁶

Can we stop this already? I promise to keep fighting this losing battle.

Phone a friend

The Fed was late in raising interest rates in the aftermath of the pandemic. Some are now arguing that they should have been cutting interest rates months ago. Why, then, do we let bureaucrats determine short-term rates rather than rely on the free market? I posed the question to Arnab Das, Global Macro Strategist at Invesco. His response:

“If you have a fiat currency, you must have an anchor for inflation. Targeting inflation requires the setting of interest rates. It can’t be left to the market. The alternative would be something like a gold standard or inviolable rules such as the Taylor rule or a money growth rule. Reverting to the gold standard or to a set of rules would require tolerating more interest rate volatility and would likely result in a less financialized economy. It would also likely result in more severe economic downturns, as there wouldn't be a policy authority with the tools required to counteract severe recessions.”

On the road again

I tend to accrue fewer travel miles during the dog days of summer. Rather than regale you this month with tales from my work travel, I’ll offer an observation from recent weekend travels to different vacation spots on Long Island and the Jersey Shore. Let’s just say that I’ve never seen these locations more crowded. The line for the exercise machines at a YMCA in eastern Long Island was stunning, and don’t get me started on the restaurant waitlists. The US economy may be slowing, but anecdotally, Americans still seem to be showing themselves a pretty good time.

I’ll conclude with quotes from Presidents Trump and Biden, respectively. “This is a chance to bring the whole country… together.” “It’s time to cool (the political rhetoric) down.” I hope so, and I couldn’t agree more.