How soon is now? The Fed says time has come to cut rates

Jack Meskunas of Oppenheimer & Co. takes a look at what might be ahead for the US economy.

In 1984, in “How Soon is Now?” UK band The Smiths sang: 

When you say it’s gonna happen ‘now’

well, when exactly do you mean?

See I’ve already waited too long

and all my hope is gone…

On Friday August 23, chair of the US Federal Reserve Jerome Powell said that the time for a change in policy has arrived—we have had tight monetary policies since early 2022. Everyone, including me, interpreted this as meaning that the time has come for a cut in rates—something I first discussed in an article in this publication on June 9, 2023. 

While “all my hope” may not be gone, this has already taken too long. The signs were on the wall, in the streets, and in the markets that a rate cut was overdue. 

The stunning revelation that job creation figures were overstated by almost one million jobs in the last year was just one more example of government ineptitude at best, or cooking the books at worst. This adjustment “erased” one-third of all the jobs allegedly created under the current administration. This was the largest revision since the great recession of 15 years ago! Suddenly all those questioning why the “average American” thought the economy was a mess finally have mathematical proof as to why.

“Government policies, particularly excessive government spending, could cause the Fed to pause rate reductions.” Jack Meskunas, Oppenheimer & Co

Still don’t fight the Fed

The adage in the markets of “Don’t fight the Fed” has been on clear display the last few years. As the Fed changed its tune from “inflation is transitory” to raising rates faster than ever (but not higher than they have been, historically), coupled with ceasing bond purchases and letting assets mature without reinvesting (reducing liquidity/tightening the markets), short-term rates and money market rates jumped accordingly. 

Longer rates (determined by traders and the markets, not the Fed) also increased, but remained stubbornly lower than short-term rates—a sign that market professionals believed what has turned out to be true—that the economy was fundamentally weakening and that rate cuts would be coming soon. This situation is called an “inverted yield curve” and has been a necessary component of every Bear market, and recession. The situation is improving as the yield curve has been “flattening” over the last 14 months (Figure 1).

Figure 1: The yield curve from June 9, 2023 vs the August 26, 2024 curve

We got the Bear market in 2022, and nearly everyone predicted recession for 2023. I called for no recession as I believed rate cuts were forthcoming, and the trillions of stimulus dollars and high cash balances of consumers were sitting on the sidelines. It was my contention that these facts would allow markets to avert a proper recession. It appears now that the one person whose opinion matters—chair Powell—is now “in my camp” as well.

The effects on captive investment portfolios have been—and will continue to be—powerful. Time is very short for captives to get out of cash, out of money-market accounts, and make a dash to extend duration.

This idea—that I have been floating in the press, in interviews, and in my own notes to clients for the last 15 months—is that extending duration in a fixed-income portfolio could make for outsized returns. In plain English, buying bonds that mature in the 3 to 5-year time frame will allow captives to potentially get double-digit rates of return in the bond market, with a combination of appreciation in the price of the bonds coupled with the “locked in” yields of ~5 percent

What about equities?

Equities are a discounting mechanism. What this means is that equities try to anticipate future moves in the markets, and are primarily driven by the moves expected to occur in the bond market. It is this very anticipation of lower rates that explains the outsized returns for equities in 2023 and so far in 2024.

The fastest-growing companies rely on liquid markets and cheap borrowing. If rates are coming down, this bodes well for equities of all sizes, but particularly for smaller companies most reliant on the domestic economy and restricted (by size) to borrowing from banks and not the overall capital markets. As such, they are very sensitive to rates.

We can see the optimism flooding into the small and mid-cap space as the S&P 600 Small Cap Index outperformed the S&P 500 Index during the month of July, when interest rate speculation was peaking (Figure 2).

But what about November?

One would need blinders on to not think about the upcoming election, and how the proposed policies of the candidates (to the extent we know them) could affect stock and bond market valuations, and captive insurance company portfolios.

In the WSJ on Friday, August 23, 2024, reporter Greg Ip wrote an article titled “In Campaign ’24, RIP Economics.” From what we know so far, both presumed candidates look to make “Economics” the big loser, with both camps offering suggestions to eliminate taxes on tips, introduce price controls, apply tariffs on almost every import, and increase tax giveaways in the form of increased child tax credits, ending taxes on Social Security payments, and perhaps even giving tax credits for buying homes—sure to increase prices in an already tight housing market. All this makes me think of the title of another song by Morrissey:  November Spawned a Monster.

I will be watching the markets and the polls closely and will be looking for policy positions to be stated where now there is just conjecture. Government policies, particularly excessive government spending could cause the Fed to pause lowering rates and ratchet back inflation. Captive insurance companies need to monitor their portfolios and be prepared to make allocation tweaks in the face of new market information.

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