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Market prepares for likely Federal Reserve rate cut

Market prepares for likely Federal Reserve rate cut
Key takeaways
Federal Reserve.
1

Anticipation for a Federal Reserve (Fed) rate cut has hit fever pitch, helping to fuel a big rally for stocks, especially tech, last week.

A gradual shift?
2

I expect the Fed to cut by 25 basis points, not 50, as a 50 basis point cut could raise alarm bells about the state of the US economy.

The US economy.
3

Fed Chair Jay Powell’s press conference could help build confidence for those worried about a US recession in the near term.

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 one rate cut 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.

Dates to watch

Date

Event

What it tells us

Sept. 16

Eurozone Labor Cost Index

 

 

Tracks the total cost on an hourly basis of employing labor

 

Empire State Manufacturing Index

 

Provides a monthly survey of manufacturers in New York State

Sept. 17

German ZEW Economic Sentiment Index

 

Measures economic sentiment in Germany for the next six months

 

 

US Retail Sales

 

Indicates the health of the retail sector

 

US Industrial Production

 

Indicates the health of the industrial sector

 

Canada Consumer Price Index

 

Tracks the path of inflation

 

US NAHB Housing Market Index

 

Indicates the health of the housing market

 

New Zealand Westpac Consumer Sentiment

 

Measures the change in the level of consumer confidence in economic activity

Sept. 18

UK Consumer Price Index

 

Tracks the path of inflation

 

New Zealand Gross Domestic Product Growth

 

Measures a region’s economic activity

 

UK House Price Index

 

Indicates the health of the housing market

 

Eurozone Consumer Price Index

 

Tracks the path of inflation

 

UK Producer Price Index

 

Measures the change in prices paid to producers of goods and services

 

Bank of Canada Summary of Deliberations

 

Gives further insight into the central bank’s decision-making process.

 

FOMC Monetary Policy Decision

 

Reveals the latest decision on the path of interest rates

 

Central Bank of Brazil Monetary Policy Decision

 

Reveals the latest decision on the path of interest rates

Sept. 19

Bank of England Monetary Policy Decision

 

Reveals the latest decision on the path of interest rates

 

Norges Bank Monetary Policy Decision

 

Reveals the latest decision on the path of interest rates

 

South African Reserve Bank Monetary Policy Decision

 

Reveals the latest decision on the path of interest rates

 

US Existing Home Sales

 

Indicates the health of the housing market

 

UK GfK Consumer Confidence

 

Tracks UK consumers' views of their finances and the economy now and for the next 12 months

 

Japan Consumer Price Index

 

Tracks the path of inflation

 

Bank of Japan Monetary Policy Decision

 

Reveals the latest decision on the path of interest rates

Sept. 20

UK Retail Sales

 

Indicates the health of the retail sector

 

Germany Producer Price Index

 

Measures the change in prices paid to producers of goods and services

 

Canada Retail Sales

 

Indicates the health of the retail sector

 

Canada Raw Material Price Index

 

Measures price changes for raw materials purchased for further processing by manufacturers operating in Canada

 

Eurozone Consumer Confidence

 

Tracks consumers' views of their finances and the economy

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Footnotes

  • 1 Source: Bloomberg, as of Sept. 13, 2024

    2 Source: Bloomberg as of Sept. 13, 2024

    3 Source: University of Michigan Survey of Consumers (preliminary), Sept. 13, 2024

    4 Source: Bloomberg, as of Sept. 13, 2024

    5 Source: FOMC announcement, July 31, 2024

    6 Source: Federal Reserve Board of Governors Survey of Economic Projections, Dec. 15, 2021

    7 Source: Federal Reserve Bank of New York, as of Dec. 31, 2022

    8 Source: Federal Reserve Board of Governors Survey of Economic Projections, June 12, 2024

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

  • The opinions referenced above are those of the author as of 16 September 2024.

    This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

    Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.

    Disinflation, a slowing in the rate of price inflation, describes instances when the inflation rate has reduced marginally over the short term.

    Personal consumption expenditures (PCE), or the PCE Index, measures price changes in consumer goods and services. Expenditures included in the index are actual US household expenditures. Core PCE excludes food and energy prices.

    The NASDAQ Composite Index is the market-capitalization-weighted index of approximately 3,000 common equities listed on the Nasdaq stock exchange.

    The federal funds rate is the rate at which banks lend balances to each other overnight.

    In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

    Fluctuations in the price of gold and precious metals may affect the profitability of companies in the gold and precious metals sector. Changes in the political or economic conditions of countries where companies in the gold and precious metals sector are located may have a direct effect on the price of gold and precious metals.

    Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

    Tightening monetary policy includes actions by a central bank to curb inflation.

    Easing refers to the lowering of interest rates and deposit ratios by central banks.

    The Survey of Consumers is a monthly telephone survey conducted by the University of Michigan that provides indexes of consumer sentiment and inflation expectations.

    A basis point is one-hundredth of a percentage point.

    The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.

    The Federal Open Market Committee (FOMC) is a committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

    Gross domestic product (GDP) is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

    Inflation is the rate at which the general price level for goods and services is increasing.

    The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive.

    A risk asset is generally described as any financial security or instrument that carries risk and is likely to fluctuate in price.

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