Will the Fed still cut interest rates?

STRONG first-quarter economic data for the US manufacturing, housing and employment sectors, combined with inflation between 3.5 and 4 per cent since mid-2023, have caused markets to unwind expectations of six rates cuts for 2024. More recently some have begun to question whether the US Federal Reserve may forgo rate cuts entirely this year.

Looking back to the early 1950s, the US central bank has required two of three catalysts to be in place before it has historically begun a rate-cutting cycle. Some combination of the US industrial sector, measured by the Institute of Supply Management’s Purchasing Manager’s Index (PMI), in contraction (that is, less than 50); unemployment rising by more than 50 basis points over the previous year (the Sahm rule); and/or disinflation risks morphing into deflation with headline CPI falling below 3 per cent has preceded rate-cutting cycles in the past.

Only a systemic threat to the financial system – more common since 1995 – has overridden these catalysts. But even then, often at least one of the three triggers was present amidst a systemic threat to begin a Fed rate-cutting cycle.

Through this lens, here are some facts: The US PMI recently rose above 50 for the first time since the early days following Russia’s 2022 invasion of Ukraine; a strong non-farm payrolls report saw unemployment over the past year stay near its lowest level since the 1960s; and, inflation has remained above the 3 per cent threshold since mid-2023. The US Federal Reserve admittedly has few reasons to begin to cut rates.

New challenge

However, one new challenge facing US policymakers points in favour of an earlier-than-expected easing cycle. In 2023 alone, interest costs on the US national debt rose above US$1 trillion for the first time in history. While national debt outstanding rose by nearly US$2.5 trillion, nearly 60 per cent of the 2023 increase in interest costs came from the nearly 50-basis-points rise in average coupons paid on outstanding Treasury securities in the year.

This level of debt service accounted for almost 15 per cent of total tax receipts and 2.4 per cent of gross domestic product (GDP). The only time US federal debt service was above this level in the post-war period has been in the early 1980s amid the Cold War military build-up and tax cuts of former US president Ronald Reagan.

With the US economy showing signs of recovering, projections from the US Congressional Budget Office suggest that the American deficit can moderate, though still adding US$1.5 trillion to US$2 trillion to the outstanding debt. Even if average coupons on Treasury securities stabilise, this could still translate into total interest costs reaching US$1.1 trillion in the current year. With nominal GDP slowing as inflation eases, this has the potential to increase the debt service burden on the US Treasury.

However, with the US government having turned to shorter-dated T-bills to finance much of its deficit over the past year despite an inverted yield curve (that is, short-dated yields higher than long-dated yields), the US Treasury could benefit meaningfully from a cut in policy rates by the Fed.

Admittedly, such a cut might not only stimulate the real economy, but also spur the still moderately elevated inflation, raising overall nominal GDP growth (and associated tax collections). Counter-intuitively, this might allow US interest costs as a share of both tax revenues and nominal GDP to retreat from the levels of the late-1970s and early-1980s.

Difficult choice

Thus, a rising US debt burden has left the Fed potentially facing a difficult choice. It could maintain its inflation-fighting stance in the face of still-elevated inflation, amid a near-full employment recovery in the US industrial economy. This could potentially challenge US debt sustainability should it breach Reagan-era debt service burdens. Or, the Fed could amend its inflation-fighting focus to help ensure US debt sustainability, especially going into a fraught US presidential election season and potential political transition.

The gradual pivot in Fed rhetoric since October 2023 may provide some guidance as to the path it may choose. Recall that at the Federal Open Market Committee’s (FOMC) September 2023 meeting, the committee noted that, “... economic activity has been expanding at a solid pace”; and “Job gains have...remain(ed) strong, and the unemployment rate has remained low. Inflation…remains elevated.” This language has largely remained unchanged through the March 2024 meeting.

However, in late October, when 10-year US Treasury yields had risen to 5 per cent, not only did the US Treasury Secretary slow the issuance of long-dated debt to take pressure off bond markets, but the US FOMC also began a slow pivot from its pause begun in July 2023.

By December 2023, the FOMC minutes signalled that “the policy rate was likely at or near its peak for this tightening cycle”, with committee members pencilling in three rate cuts by end-2024. Moreover, despite the strong first quarter economic data, the Fed maintained its outlook for rate cuts and augmented this prospective policy stance – by signalling at the March 2024 press conference that a decision was near regarding a slowing of the Fed’s quantitative tightening programme, which drains liquidity from the US economy.

The only time we have witnessed the Fed slowing its pace of quantitative tightening and cutting interest rates was in 2019 when the US industrial economy was expanding and unemployment was, like today, steady – averaging 3.5 to 4 per cent.

In 2019, however, the Fed’s preferred inflation gauge – core PCE (personal consumption expenditure) – was already slowing from 2 per cent to start the year, to 1.5 per cent by mid-2019. This, in combination with spreading turmoil in US money markets, kicked off the 2019 rate-cutting cycle prior to the return to zero-rate policy of the global pandemic.

By slowing its quantitative tightening programme, before renewed stress begins to build in the system following the Silicon Valley Bank failure a year ago and the end of its emergency liquidity facility, the Fed appears to be seeking to pre-emptively loosen balance sheet policies and potentially interest rate policies. Its goal may be to strike a balance not only between inflation and debt sustainability, but also between inflation and financial system stability risks.

Thus, even though the catalysts that have guided the Fed rate-cutting function since the early-1950s are yet to be met, debt sustainability and financial system stability appear to be rising on the Fed’s priority list.

For equity investors, this suggests that catalysts to spur the next leg of upgrades to earnings expectations should emerge in the months ahead, providing an opportunity for investors who have missed out on the nearly 25 per cent rally in global equities since October 2023.

As bond investors should see continued interest volatility, with inflation expectations still modest by historical standards, income-focused credit exposure rather than the anticipation of sustained falls in interest rates should drive fixed income returns moving into the summer.

The writer is group chief strategist at Union Bancaire Privee, a private bank and wealth management firm