Rate cuts locked in, but be careful what you wish for
AFR-Chanticleer
Jerome Powell gave the market the green light on rate cuts, and stocks rallied. But investors’ extreme positioning ignores an unpredictable market backdrop.
Aug 24, 2024 – 9.31am
Just four minutes and 50 seconds into his speech, Jerome Powell gave the market what it wanted.
“The time has come for policy to adjust,” the Federal Reserve chairman said in his long-awaited speech at the Fed’s annual Jackson Hole symposium. “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
In its childish way, investors heard what they wanted to hear, and acted accordingly. Powell confirmed that the Fed will pivot to rate cuts, Wall Street leapt higher and bond yields fell.
The mini-heart attack that roiled global markets a few weeks ago is a fading memory, with the market resuming its steady march higher; the S&P 500 is now up 19 per cent for the year, and almost 37 per cent from last November, when this bull market rally really got going.
The Fed’s pivot is warranted by disinflation and the softening of the labour market. The 0.9 per cent increase in US unemployment from its cyclical lows is something the Fed and investors cannot ignore. Powell’s right: the time has come for rate cuts.
But the market’s reaction, while predictable, displays a lack of logic.
“In the first 200 days following the first cut, equities typically decline by 23 per cent on average. The start of the rate cycle signals the beginning of a deterioration in growth and profits,” Ferres says.
Following Powell’s speech, money markets continue to predict that US rates will fall by 1 per cent by the end of 2025. There’s only three meetings left – September, October and November – so that assumes we get one 50 basis point cut somewhere along the way.
Cuts of that magnitude are typically reserved for emergencies – and emergencies are not great for stocks.
But no hint of caution is priced into markets.
As Ferrers says, Wall Street’s steady march higher following this month’s brief but brutal market rout means valuations are once again approaching extreme levels, and equity risk premium – the earnings yield on riskier equities compared to the low-risk bond yield – is all but non-existent. Two scenarios to consider
Investors are all-in on the same Goldilocks scenario that has driven this market higher for almost a year: we get a perfect soft landing with just enough rate cuts, corporate profits grow at a double-digit rate in 2025 despite a softening economy, and the artificial intelligence boom rolls on in perpetuity.
Maybe that’s all correct. But if there’s one lesson we should learn from the market sell-off, it’s that extreme positioning provokes extreme reactions – and no risk assets are spared.
Chanticleer suggests there are two scenarios that investors should at least consider before they swallow the ‘rate cut equals rally’ line.
The first is that a soft landing could become something harder.
Just 10 weeks ago, in the central bank’s projections provided at its June meeting, the Fed dropped two of the three easings previously anticipated, raised its core inflation forecast, and said it expected unemployment to remain unchanged for the remainder of the year.
But at Jackson Hole, Powell was singing a very different tune, declaring “the downside risks to employment have increased”.
The rate of change here is striking and a reminder that soft landings are exceedingly rare, occurring in just two of the 12 major US downturns since 1957.
The second scenario is that Powell is forced to backtrack on his pivot.
Bank of America’s Michael Hartnett points out that inflationary pressures may be building: global shipping costs are up four-fold since November 2023 due to the conflict in the Middle East, protectionism is rife, industrial unrest is becoming more common across the globe (including big strikes are underway in the North American transport sector) and energy costs keep rising, in part due to the AI boom. On top of this, governments keep spending, and that won’t stop given election cycles around the world.
Hartnett argues the US economy desperately needs rate cuts, with inflation-adjusted business rates at 20-year highs for small businesses. But what if it turns out Powell can’t deliver that support because inflation kicks back up?
Both of these scenarios may prove unlikely. But they can’t be completely discounted either, and herein lies the key point.
Investors remain utterly convinced that the Goldilocks soft landing will happen, and their extreme positioning creates huge potential for volatility and dramatic shifts in sentiment.
As Powell himself said on Friday night, a big turning point like this demands “humility and a questioning spirit focused on learning lessons from the past and applying them flexibly to our current challenges.”
That may turn out to be the line the market should have paid the most attention to from this speech.
