Market prepares for likely Fed rate cut

Last week was a strong one for stocks globally, led by US equities. And US equities were led by the technology sector, with the NASDAQ Composite Index rising almost 6% in one week — its best week since last November.¹ Why? I certainly think part of the story is that tech has underperformed in recent weeks, and so investors were scooping up relative bargains. But there are two key drivers, in my view: anticipation of a very substantial easing cycle by the Federal Reserve (Fed), and concerns about US economic growth.

Data indicates the Fed is free to start lowering interest rates

US inflation concerns have largely been put to bed, which frees up the Fed to move forward with loosening monetary policy — and that could take pressure off higher valuation assets such as tech stocks. Technology stocks are considered a “long duration” asset class, meaning they are typically more sensitive to interest rate changes because their earnings stream is farther out in the future.

Both market-based and survey-based measures of inflation expectations indicate that inflation is no longer a significant concern, which helps open the door to a significant easing cycle:

• The 5-year breakeven Treasury inflation rate is now below 2%, the Fed’s target.²
• The preliminary reading of the University of Michigan’s one-year ahead consumer inflation expectations for September dropped to 2.7% — its lowest level since December 2020.³

Economic concerns may boost interest in the tech sector

In recent years, tech has become a favored sector for investors looking for secular growth in the face of weak economic growth expectations. And we’ve seen economic growth concerns manifest in different ways, including:

• The 10-year US Treasury yield experienced its lowest weekly close since May 2023.⁴
• Gold, broadly regarded as a “safe haven” asset class, hit a new high last Friday, piercing $2600 per ounce.⁴
• Oil prices have fallen not just on increased supply but on concerns about reduced global demand (although in recent days we saw a rebound because of Hurricane Francine).
• The European Central Bank (ECB) has made downward revisions to its growth forecasts.
• Former ECB president and former Italian Prime Minister Mario Draghi issued a report on European Union competitiveness, which worries about weak economic growth and prescribes large-scale investment to achieve economic reform.

Markets are clearly experiencing mixed feelings — trepidation about an economic slowdown and excitement about imminent rate cuts.

What to watch with this week’s Fed meeting

The Federal Open Market Committee (FOMC) will issue its rate decision Sept. 18. Here’s what I’ll be watching:

The size of the rate cut

I expect the Fed to cut by 25 basis points, not 50. As I’ve said before, I believe a 50 basis point cut would raise alarm bells about the state of the US economy. Recall that the Fed started a brief easing cycle with a 50 basis point cut in March 2020 with the global pandemic upon us; it would be very hard to argue that the situation is so dire now and necessitates a 50 basis point cut.

In fact, the last time the Fed started a policy change, it did so with a gradual move: Even when the Fed was admittedly behind the curve in raising rates to fight inflation in March 2022, it did not start with a 50 basis point hike. It started with a 25 basis point move and quickly graduated to larger hikes. Having said that, assuming the Fed cuts by only 25 basis points this week, it will be interesting to see how many FOMC participants voted for 50 basis points. A relatively high number points to a more aggressive easing path going forward.

The language in the FOMC announcement

Comparing this announcement to the last one will shine a light on minor tweaks in language. In particular, I would be interested to see how the economy is characterized in this announcement versus the last one.

For example, in the July FOMC announcement in its assessment of the economy, the Fed characterized GDP growth as “solid,” but the FOMC acknowledged that job gains have “moderated” and noted that the unemployment rate has “moved up.”⁵ I would anticipate similar language this time around; more negative language could raise a red flag.

However, the language is less important this time around because we will be getting projections for both unemployment and gross domestic product (GDP) growth from FOMC members in the Summary of Economic Projections.

The dot plot and other projections

The FOMC Summary of Economic Projections (the SEP) contains the dot plot and several other charts of projections:

• The dot plot. This will give us a good sense of what FOMC members anticipate in terms of rate cuts in the coming year. I expect this dot plot to show about 200 basis points in cuts in the coming 12 months, but the Fed could surprise us. And I think it’s worth noting that the Fed can be rather inaccurate in its predictions. For example, its December 2021 dot plot anticipated a fed funds rate of 90 basis points at the end of 2022,⁶ when in fact it was well over 400 basis points at the end of 2022.⁷ Similarly, the June 2024 dot plot anticipated a median rate cut of 25 basis points by the end of 2024,⁸ which seems to be an underestimate at this juncture; I would anticipate the September dot plot increasing to 75 basis points in cuts in 2024. We also want to look to the dot plot to get a sense of what the Fed views as the longer-term neutral rate. In the June dot plot, it was 2.8%⁸, up from 2.6% in the March dot plot.⁸ I would be surprised to see it change again.
• Unemployment rate projections and GDP growth projections. As mentioned above, this will provide the best indicator of how FOMC members view the state of the US economy. In the June 2024 dot plot, the Fed anticipated unemployment to be at 4% at the end of 2024, which we have already overshot, and 4.2% at the end of 2025.⁸ I expect the forecast to be revised upward for both 2024 and 2025; by how much will give us a sense of how much the Fed anticipates the labor market will weaken. Despite higher unemployment, I anticipate the Fed’s GDP growth forecast for 2024 will be revised modestly upward as well, reflecting better recent growth. It would be concerning if the Fed revises down GDP growth expectations for 2025, although I think it is unlikely to happen; I am actually hopeful the Fed might upwardly revise its GDP growth forecast for 2025. Interestingly, after the 1995-1996 easing cycle began – this followed what was the last tightening cycle that didn’t result in recession -- we saw GDP growth increase significantly. While I don’t expect a repeat of 1996, I do believe some FOMC members may anticipate a more positive growth outlook, especially given the productivity boost and continued technological advancements and innovation. Maybe that’s a pipe dream for me, but I will be looking closely at growth projections.
• Inflation projections. As mentioned, US inflation has become far less relevant in just a few weeks. However, it will still be important to see when the Fed anticipates inflation will reach its target. The Fed provides projections for both headline Personal Consumption Expenditures (PCE) and core PCE in the SEP. As of June, the Fed anticipated core PCE would not reach the Fed’s 2% target until 2026.⁸ I suspect that timeline could be moved up given significant disinflationary progress this summer.
• The press conference. What Fed Chair Jay Powell says in his press conference about the state of the US economy could help build confidence for those worried about a recession in the near term. Back at the July press conference, Powell said he was not seeing weakness in the economy and likened the current economy to 2019 conditions. I suspect he will say something similar this week, although there is always the possibility he signals some concerns about the economy weakening. In addition, it will be valuable to hear Powell’s thoughts on the expected path of rate cuts – in particular, what conditions could trigger a change of course, either a moderation or acceleration in easing. These are just things you can’t glean from the dot plot so the press conference is “must see TV” in my view.

Global central bank decisions happening this week

• Bank of England. Consensus expectations are for the Bank of England to hold, which makes sense after two rate cuts and relatively strong economic conditions. But I won’t entirely dismiss the possibility of another rate cut given significant disinflationary progress in terms of wage growth and services inflation.
• Bank of Japan. Given recent market turmoil, I agree with the consensus view that the Bank of Japan will hold firm and not hike further at this meeting. It is prudent and appropriate to forego a rate hike this week. There is a possibility of a rate hike at the Bank of Japan’s next meeting, although it seems far more likely to occur at the December meeting.
• Norges Bank. Norway’s central bank has been stubborn about not cutting rates. Conventional wisdom is that this bank will not cut until December, but now that other major central banks have cut more than once and the Fed is poised to begin cutting, I think there is a small possibility of a rate cut this week – especially given that inflation has fallen faster than the central bank’s forecasts. It certainly would be symbolic in supporting the narrative that much of the world is embarking on the start of easing.

Conclusion

In summary, the path has been cleared for a Fed rate cut this week and arguably marks a new phase in the global easing cycle. But we should not assume it will be smooth sailing for risk assets from here. There is still significant uncertainty that will cause market volatility, from the potential for a US government shutdown to the US presidential election to the path of central bank easing – and of course what kind of landing we will see in different major economies. As such, I believe data points indicating the health of the economy will have a far larger impact on markets going forward and will contribute to volatility as well as style and sector rotations in the near term.