One of our favourite expressions in the last cycle was, never underestimate the Fed’s ability to out-dove the market. The implication is that there was an asymmetry in the Fed’s policy bias to defending the left tail or downside risk for the economy (and markets). Although we would argue that the Fed’s desire for “stability” (to smooth the business cycle) paradoxically contributes to eventual instability via a build-up in leverage, positioning (in all forms) and the inevitable unwind as we witnessed in August. Of course, the late July, early August drawdown was probably just a preview or tremor ahead of a more challenging episode in October.
Short term interest rate markets expect aggressive Fed rate cuts, starting with the 50:50 prospect of a 50-basis point cut on Wednesday at the September FOMC. Our sense is that the Fed probably ought to be cutting by as much as 75 basis points (more on that below). However, we would lean toward 25 basis points being delivered. Our sense is that the 50:50 odds simply reflect the split consensus at the FOMC, the optics of a larger cut with six weeks to go until the November election while the stock market is near the all-time-high.
At the same time, our sense is that the Fed might be as much as 250 basis points above neutral and probably ought to be cutting the funds rate by at least 75 basis points at this meeting. We acknowledge that this point is controversial. Especially if, as Gerard Minack eloquently argues, the Fed (and the markets) are underestimating the neutral rate. If the neutral rate is higher than it was in the previous cycle, the easing cycle could overshoot to the downside and might set up a quick pivot to tighter policy in 2025. Especially if the fiscal ill-discipline returns with a new US administration and contributes to a re-acceleration in consumer price inflation. A related factor in this cycle was that households and business locked in low rates on debt and muted the impact of a higher policy rate.
From our perch, the observations above reflect the unusual lags in monetary policy in this cycle. As we have noted previously, there have been several head fakes or transitory growth fears that were subsequently unwound by what some observers termed “the big flip.” However, the recent macro news flow is no longer a recession head fake or transitory growth scare. The labour market has turned and turned hard.
While fiscal policy remains supportive and the service sector is still growing, US and global cyclical deterioration is consistent with a more sinister growth scare and potential “hard landing.” Our sense that is also evident in the gap between the Fed funds rate and the 2-year Treasury yield (chart 1). For investors, the implication is that the downside risk to growth and earnings is under-priced, or risk compensation is unattractive. We would fade any enthusiasm for equities on a Fed rate cut, especially and paradoxically if the central bank eases by 50 basis points (or more). Of course, the Pavlovian response might be bullish in the very short term. We have a low net long equity position. On Wednesday, never underestimate the Fed’s ability to out-dove the market.
Chart 1
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