Because inflation is starting to drop, the U.S. central bank can finally do what investors have been waiting for all year: lower interest rates. This will be the first time since March 2022 that rates were raised more quickly than ever before.
Inflation needs to be beaten decisively, but the world’s largest economy needs to stay out of recession or at least avoid a deep and long-lasting one. This seems like an impossible task for the Federal Reserve and Chairman Jerome Powell.
Investors have a lot at stake now that U.S. stocks have hit more record highs over the past week. At 5,633.91 and 18,647.45, the S&P 500 SPX and Nasdaq Composite COMP both hit their 37th and 27th all-time highs for the year on Wednesday. This happened after Powell spoke to Congress for two days and seemed to move the central bank closer to lowering rates.
Powell said again that policymakers are in a tough spot because lowering interest rates too little or too late could hurt the economy, but lowering them too much or too soon could undo the progress made on inflation. The Fed’s job is to keep prices stable and ensure that everyone has a job.
People in the financial markets seemed to reach a turning point in their thinking when they started to stress how dangerous it is to lower interest rates too late. All three major stock indexes went up for the week, but the S&P 500 and Nasdaq closed below their record highs on Wednesday. This was due to the growing chance that interest rates would be lowered as soon as September.
The chief investment officer at Apollon Wealth Management, which is based in Mount Pleasant, S.C. and manages about $7.5 billion, Eric Sterner, said, “What’s at stake is a hard landing where we could see the unemployment rate go up, consumer spending go down, more layoffs, and potentially a bear market where there is an earnings and economic recession.” When a company’s annual profits go down for two straight quarters, this is called an earnings recession.
“My base case is for a soft landing,” Sterner said over the phone. “Both small- and large-cap companies are looking optimistic about earnings for this year and next.” That’s the first time since 2021 that all 11 sectors of the S&P 500 could have positive earnings growth in the fourth quarter, he said.
The pattern of Fed rate hikes and cuts in the mid-1990s shows Powell might be able to pull off the tricky trick of a soft landing, even though some strategists are worried about how bad any downturn will be.
In 1994, when Alan Greenspan was Chairman, the Fed raised interest rates by 2.5 percentage points, from 3% to 5.5%, to cool down a hot job market, keep inflation in check, and keep the economy growing. As strategist John Velis of BNY Mellon put it, it was the first and only time in decades that policymakers were able to raise rates without starting a recession. According to the Fed’s regional bank in Richmond, Virginia, inflation, which is the central bank’s preferred measure, never went above 2.3% during that time. This is different from now, when prices are going up.
The fed funds rate was raised by another half-point in early 1995, bringing it to 6%. In July 1995, December 1995, and January 1996, rates were lowered by quarter-points each to protect against a possible recession. Even though the S&P 500 was going up at the time, they did this.
There was growth in the economy until March 2001, a year after the dot-com bubble started to pop. Between 1997 and 2000, the Fed raised and lowered interest rates more times. It also made it through the Asian financial crisis of 1997, the chaos in Russia the next year, which caused the ruble to lose value, and the failure of a hedge fund called Long-Term Capital Management.
Lawrence Gillum, a fixed-income strategist for broker-dealer LPL Financial in Charlotte, N.C., said, “It’s such a hard thing to do, and the odds are stacked against it, but you have to say,’so far, so good,’ and it might be possible.” “One could say that the price of a soft landing, or perfect deflation, is already taken into account.” Should something else happen, like a hard landing or a drop in the economy, risk assets might get a rude awakening.
Interest rates have been stuck between 5.25% and 5.5% for a year now. This is long enough for the rates to start having an effect on the economy, as shown by the fact that GDP growth was slow in the first quarter, job gains were revised down, and consumer prices dropped in June. This week’s economic data includes the U.S. retail-sales report for June, which came out on Tuesday and will show how well American consumers are doing.
Gillum told me on the phone, “Right now, the risk of cutting rates too late is bigger than the risk of waiting.” Even so, rate cuts are “absolutely” dangerous for the stock market because they might cause inflation to start rising again. “We think that inflation is still high and that we won’t get back to the Fed’s 2% inflation target for a while.” I’ve been telling clients that it’s not possible to price in three rate cuts. This year, we expect two.
Fed-funds futures traders thought there could be as many as six or seven rate cuts in 2024 at the start of the year, but then changed their minds. They now think there is a good chance of five or six quarter-point cuts through June of next year, with the first one coming in two months. In the meantime, San Francisco Fed President Mary Daly spoke out after the consumer price index for last month was released on Thursday to say that she now supports lowering interest rates.
Sterner of Apollon Wealth Management was one of the first people who thought that inflation would need to be fixed by a recession. He said he has changed his mind now.
For him, this cycle is different from others because people have kept spending despite high inflation by using savings they built up during the COVID lockdown; the government has spent more because of fiscal stimulus; and private credit funds have stepped in to lend money to mid-sized businesses that have kept them going.
