Jay’s blunt scalpel

Rate cuts are not the main game, it’s liquidity that matters

Even though liquidity (the availability of money) is the biggest driver of asset prices in financial markets, the Federal Reserve’s (Fed) decisions on interest rates are always a hot topic for investors.

Currently, markets expect six to seven small interest rate cuts of 0.25% each.

But what happens if these anticipated cuts are smaller or fewer than expected? Instead of deep, aggressive cuts, the Fed might opt for more moderate reductions.

If there’s no major disruption in the bond market, banking system, or another unexpected event like a pandemic or oil crisis, why would the Fed make deep cuts and risk the return of inflation? In short, it wouldn’t.

No justification for a sharp scalpel

I wrote this back in January where I described it as “no pivot but maybe a few small adjustments” and again in February.

Fast forward to today and consider the Fed’s preferred measure of inflation, Core Personal Consumption Expenditure (PCE), which in May printed 2.6%, which is still above the Fed’s 2% target.

This data suggests keeping rates higher for a little longer to keep overall demand in check, and that the current Fed might choose smaller rate cuts to avoid reigniting inflation. And it might only need one or two cuts made with a "blunt scalpel" to achieve its desired goals.

Historically, the Fed has only made deep cuts in response to major catalysts like the GFC or COVID-19. Without a similar catalyst, deep cuts are unlikely. As a result, if the market’s expectation of several near-term rate cuts is unwarranted and a new "blunt scalpel" narrative starts to be priced in, this could have substantial effects on stocks.

Blunt scalpel implications for the stock market

Moderate rate cuts might not provide the boost needed to meet optimistic growth expectations in the stock market. For instance, the lowest annual earnings forecast for the S&P500 is 11.4%, much higher than the actual economic growth rate of 1.4% in the first quarter. That said, while long duration technology company valuations may continue to sell off, interest rate-sensitive stocks could do well once their cost of capital reduces after minor rate cuts.

Blunt scalpel implications for bonds

In contrast, short-term bonds could benefit from even minor rate cuts, offering safer returns compared to equities. Long-term bonds are less appealing now, as their yield premium over short-term bonds is minimal. This mispricing is reminiscent of the GFC period, but without today's stable environment, the repricing of these bonds could lead to rising yields and falling prices. Overall, there’s likely way less risk in the front end of the yield curve, i.e., bills and short terms bonds.

Price action

Stock markets have started to consider the possibility of moderate rate cuts, with professional investors reducing equity exposure and increasing short-term bond holdings. This trend aligns with the Treasury's strategy under Janet Yellen, emphasising short-term financing and it does not smack of a rotation from mega tech to the other 493 stocks in the S&P500. Rather, it feels like a rotation between entire asset classes due to current interest rate policy and earnings expectations, as well as the macro landscape that investors are expecting by the end of the year, post-elections. You can read more about the conductivity of bonds and cash versus stocks, here.

Could Harris derail the Trump trade?

And talking about elections, the November presidential elections add a thick layer of uncertainty. Up until Biden pulled out of the race, Trump appeared to be doing quite well. And we have a pretty good idea that under Trump, we could expect increased money supply which favours higher-risk investments like stocks and cryptocurrencies.

But just as his election hopes seemed to rocket on the back of a failed assassination attempt, so too did the Democrats’ hope of an election win when Kamala Harris was endorsed not only by Charli XCX, when she tweeted ‘Kamala IS brat’ but also when she won endorsement from not so brat speaker, Nancy Pelosi.

There’s a vote still to come in August, but as of today it looks like it will be a battle royale between Trump and Harris.

Final thoughts

In summary, the financial landscape is poised for significant shifts driven by the Fed's potential "blunt scalpel" approach to rate cuts. Moderate reductions in interest rates, aimed at balancing growth and inflation, may not provide the anticipated boost for high-growth stocks but could benefit interest-rate-sensitive equities and short-term bonds.

The upcoming presidential election adds a layer of uncertainty, with potential policy changes under different administrations impacting market dynamics. Investors should keep a close eye on these developments, as the return of Trump could introduce more liquidity into the market, favouring higher-risk assets like stocks and cryptocurrencies.

Meanwhile, Australia faces its own challenges with high non-tradeable inflation and a low unemployment rate of 4.1% as of June, suggesting the RBA will also be making critical decisions soon, though the direction may differ.

Is it time to keep a closer eye on what’s happening in the land of the free and home of the brave? Absolutely.

Mike

Michael GanonJuly 23, 2024#money, #management, #markets, #investing, #technology, #india, #future, #finance, #executivesandmanagement, #businessintelligence, #fundraising. #strategy, #managementconsulting, #business, #wealthmanagement, #sustainability, #venturecapital, #investmentbanking, #entrepreneurship, #economy, #gold, #silver, #bitcoin, #corporatedev #corporatedevelopment #miningandconstruction, #strategy, #commodities, #corporatefinance, #equities, #stocks, #bonds, #economics, #macroeconomics, #ethereum, #inflation, #qeinfinity, #interestrates, #trade, #transformation, #ceos, #directors, #founders, #cfos, #currencies, #construction, #mining, #renewables, #leadership, #china, #australia, #education, #research, #businessowners, #brexit, #community, #covid, #populism, #crypto, #successionplanning, #familyoffices, #uranium, #copper, #nickel, #Fed, #federalreserve, #monetarypolicy, #centralbanks, #marketoutlook, #financialmarkets, #stockmarket, #valuation, #SP500, #realestate, #foreignexchange, #humanresources, #productivity, #continuingeducation, #financialanalysis, #CPA, #CFP, #CFA