September's 50-Basis Point Rate Cut
On September 18, the US Federal Reserve lowered the federal funds rate by 50 basis points (bps). The current rate now stands between 4.75% to 5.00%. The cut was aligned with expectations, as reflected in CME’s Fedwatch, which prior to the revision was reporting a nearly 60% probability of a 50-point change.
The large cut, the first since 2020, was driven by August jobs data in which non-farm payrolls increased by 142K, unemployment was 4.2%, and hourly earnings increased by 0.4%. The payroll data fell short of expectations but was a significant improvement over July’s numbers (Group 2024). Both the unemployment and the hourly earnings growth rate met estimates. The jobs data is a primary factor the Federal Open Market Committee (FMOC) considers when determining the benchmark rate.
The second factor informing Fed action is inflation data. The August inflation report showed the CPI increased approximately 2.5% versus analysts’ estimates of a 2.6% rise. In general, the lower CPI rate was good news for the market, but economists remain concerned by sticky core inflation of 3.2%. Moreover, monthly August core inflation climbed 0.3%, outpacing July’s growth of 0.2% (Leonhardt, n.d.). Overall, the Fed judged CPI data healthy enough to withstand the potential inflationary pressures of a large cut.
Economists expect continued revisions through 2025. The Fed’s next meeting will be held on November 7. As of September 19, CME Fedwatch anticipates a 100% probability of a rate easement in November, with 68.5% of analysts anticipating a 25-basis point (bps) cut and 31.5% expecting a 50-bps cut (CME Group, n.d.). The year end 2025 Fed rate target is now 3.5%.
Effect on Portfolio
The Fed’s decision is a reaction to worsening economic signals, principally slowing jobs growth and above target inflation. The Fed must navigate each factor to achieve a “soft landing”, which is a term used to define a cyclical period of slowing economic growth that ends without a recession (Erasure and Velasquez, n.d.). What this means for portfolios is that the systematic drivers supporting market valuations are under pressure.
Historically, the effect of individual rate cuts on capital markets is mixed. A downward move in the FFR appears secondary to contemporaneous factors affecting the general economic environment. For example, rate revisions in 2001 and 2007 precipitated the Great Recession. Yet, in 85% of the 12-month periods following a rate cut since 1929 the S&P 500 has produced gains.
Chart1: 12-Month S&P 500 Returns Post Rate Cut (Sonders and Gordon, n.d.)
August jobs data and inflation expectations may both be worrisome to economists, but the Atlanta Fed’s GDPNow tracker currently stands at 2.5% after a 50bps increase on September 4 (Atlanta, n.d.). Therefore, Atlanta Fed appears to believe that the US economy will continue expanding, which is a positive sign for markets, and frames the Federal Reserve’s rate cut as a liquidity boost and not as a reaction to a structurally weaker economy.
How to Invest
Specific investments and sectors have evidenced periods of improved performance post an FFR cut (T1). As such, Avrio will add tactical allocations to client portfolios that increase exposure to long duration investments and real assets.
T1: Investment Specific Effects of a Lower FFR
Investment | Result |
Bonds | Bond values tend to increase when interest rates fall. Clients may wish to lock in higher coupons now and take more duration exposure. |
Tactical | Equity sectors that have benefited from rate cuts include consumer discretionary, information technology, utilities, real estate, and consumer staples. |
Alts. | Rate cuts will lower a company’s cost of capital (COC) which will result in less expensive investment projects. Additionally, any floating rate debt will become less expensive. Certain sectors, like real estate, should benefit, as both developer and consumer financing costs fall. Moreover, rent rates tend to be sticky, and with falling debt costs, cash flow at in-place projects should improve. Finally, the discount rate used to value investments will drop, perhaps resulting in better exit valuations. |
In summary, the federal funds rate is one of several factors that determines market performance, and investment decisions should be considered alongside the rationale for the Fed’s actions. Moreover, the market quickly prices the effect of systematic factors, such as a change in the FFR, into investment prices, and thus, capitalizing on a rate change may be difficult to time. Therefore, the optimal portfolio for long term investors continues to be a well-diversified global allocation aligned to a client’s particular goals, time horizon and risk profile.
Sources:
Group, Principal Financial. 2024. “August Jobs Report: The 25bps Vs. 50bps Question | Seeking Alpha.” September 7, 2024. https://www.principalam.com/us/insights/macro-views/august-jobs-report-25bps-vs-50bps-question.
CME Group. n.d. “CME FedWatch - CME Group.” Accessed September 2, 2024. https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html.
Leonhardt, Megan. n.d. “CPI Inflation Report Today: Consumer Prices Cool to 2.5% in August; Core Looks Stickier.” Accessed September 16, 2024. https://www.barrons.com/livecoverage/cpi-inflation-august-report-data-today.
CME Group. n.d. “CME FedWatch - CME Group.” Accessed September 2, 2024. https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html.
Rasure, Erika, and Vikki Velasquez. n.d. “Soft Landing: Definition and History in Economics.” Investopedia. Accessed September 10, 2024. https://www.investopedia.com/terms/s/softlanding.asp.
Sonders, Liz Ann, and Kevin Gordon. n.d. “What Past Fed Rate Cycles Can Tell Us.” Schwab Brokerage. Accessed September 2, 2024. https://www.schwabassetmanagement.com/story/what-past-fed-rate-cycles-can-tell-us.
Atlanta, Fed. n.d. “GDPNow.” Accessed September 10, 2024. https://www.atlantafed.org/cqer/research/gdpnow.
This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/ and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.