What to look out for after the US interest rate cut
While inflation has cooled off, there is a danger that it has not been vanquished
THE US Federal Reserve has started cutting interest rates at long last, and it is a relief that financial conditions in the US will be easing. But it is far too early to celebrate.
The stock market has been rising anyway, with the S&P 500 closing at a new high one day after the Fed’s action. Even so, there is plenty to worry about.
Start wherever you like. Personally, I begin with broad political and geopolitical concerns, not specifically financial ones, leading with the presidential election in the US, which is still too close to call. Then, when I can stand it, I survey tensions around the globe, from the hostilities in the Middle East to Russia’s war in Ukraine to incipient conflicts involving China in the Taiwan Strait and the South China Sea.
There is no shortage of explicit economic and financial issues percolating within US borders, either. The Fed depicted its decision to reduce the benchmark federal funds rate by half a percentage point as a prophylactic measure, aimed at heading off an unemployment spiral.
The economy looks fairly strong now, but unemployment has already begun to rise and in many past cycles, slowing job growth has culminated in mass layoffs. The potential for a widening economic slowdown that becomes a full-blown recession will be with us for some time.
By beginning its rate cuts with a bang, reducing the federal funds rate by twice the quarter-point minimum with which it might have started, the Fed indicated that it was reasonably optimistic that inflation would remain subdued.
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Yet in a news conference after the decision, Fed chairman Jerome Powell warned: “We are not saying mission accomplished or anything like that.”
While inflation has cooled off, there is a danger that it has not been vanquished. For one thing, a wider war in the Middle East or Eastern Europe could cause another spike in the price of oil and at petrol pumps in the US.
Domestic issues
That brings us back to the US election. The polls are close. One possibility is a Republican sweep, giving former president Donald Trump the ability to enact steep and broad tariffs, which could disrupt the economy and the markets. Another potential outcome, deemed less likely by election prediction markets, is a Democratic sweep, which could lead to higher taxes on wealthy people and corporations, upsetting the stock market.
Whoever wins the presidency will need to deal with the expiration next year of the 2017 Trump tax cuts, with trillions of dollars in taxes and revenue at stake.
There are other reasons to worry about the behaviour of the stock market. It may soon become difficult to ignore how high the valuations of many stocks have become. Using a wide range of traditional metrics, the market is expensive.
Bullish anyway
This is a glum recitation of risks, I know, and I can come up with many more. Despite all this, however, I am bullish on the stock market and intend to keep holding broad low-cost index funds for many more years.
But I am doing this with eyes wide open, accepting the likelihood of intermittent setbacks in the hope of gains, which the overall stock market has granted over long periods. There are no guarantees, though. And so, while the rate cut is a step in the right direction, as an investor I am not getting too excited.
For consumers, the initial rate cut does not mean much, either. There will eventually be reduced costs for people borrowing money through car loans, credit cards, new student loans, mortgages, business loans and more. But when mortgage rates are above 6 per cent, half a point is not a game changer. The Fed will need to follow through with more reductions for consumers to benefit significantly.
On their own, the bond and mortgage markets have already begun to give consumers some relief, easing financial conditions in important parts of the economy. Average 30-year mortgage rates, for example, dropped from 7.8 per cent in October 2023 to 6.1 per cent on Sep 19, according to the Fred database of the St Louis Federal Reserve.
The markets anticipated the Fed’s decision to reduce interest rates. What was not settled before the Fed’s announcement was how low rates would go. Now the important question for both consumers and the markets is how much further the Fed will cut, and how quickly.
A consensus of Fed policymakers projected that the federal funds rate, now in the 4.75 to 5 per cent range, would fall to about 4.4 per cent by the end of 2024, to 3.4 per cent by the end of 2025 and 2.9 per cent in 2026. Those plans amount to a sea change.
Recall that the Fed began raising rates from near-zero in the winter of 2022, when inflation was roaring. The annual increase in the consumer price index reached a cyclical peak of 9.1 per cent in June of that year. In August 2024, it was 2.5 per cent. The Fed is hoping it keeps falling to 2 per cent.
The stock market is often erratic, but it has been choppier than usual since mid-July, with big weekly declines and increases following one another. Such abrupt shifts during periods when stocks were already near a peak have generally augured poorly for the market.
Fundamental measures raise questions about the market outlook. The standard price-to-earnings ratio, as well as a more sophisticated 10-year version developed by Yale economist Robert Shiller and known as the Cape ratio, both show that prices are extremely high on a historical basis.
Other metrics also show stretched valuations, such as Tobin’s Q, popularised by Yale economist James Tobin, which compares the total price of the stock market with the value of the assets held by the companies within it.
These measures cannot reliably forecast short-term market movements, but they suggest that over the next decade, the US stock market may be weaker than usual.
Joy over falling interest rates could well fuel a protracted rally, but there are solid reasons for caution. Investment advisory Vanguard says the bond market now offers greater value than the stock market, though its long-term returns are lower.
All that underlines the need to diversify, by holding bonds as well as stocks, and to invest globally, keep costs low and avoid taking undue risks with money you cannot afford to lose.
Now that the Fed’s rate cutting has begun, don’t be surprised when financial markets worry about something else.
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