Why would the Fed cut their overnight lending rate?
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Weekly Market Outlook
By Donn Goodman
March 27, 2023
Welcome back Market Outlook readers. Glad you could join us for this week’s Market Outlook. Hope you enjoyed a profitable week of investing and trading in the positive market.
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From the newsletter:
The Federal Reserve kept interest rates on hold.
After the Federal Reserve finished meeting for two days earlier last week, Chairman Powell announced that they would hold interest rates steady. More importantly, he announced that the Fed remained cautiously optimistic that inflation is trending down as they stuck to the path for interest rate cuts to come later in the year. The Chairman conveyed that price pressure will continue to ease, and it will likely be appropriate to start cutting later in 2024.
By a small majority, Federal Reserve committee members stuck to the expectation of three cuts for the remainder of the year. Powell also indicated that slowing the pace of the reduction to the Fed’s bond holdings will come into view “fairly soon.”
Is this a change in posture?
No, but it does show that the Federal Reserve is likely willing to accept higher inflation than their long-held objective of getting inflation down to 2% for their long-term objective. See the dot pattern below indicating 3 rate cuts during 2024:
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One problem area of inflation is housing.
Housing costs remain a lingering inflationary concern and have challenged the Federal Reserve’s effort to curb rising prices. Fortunately, rents have shown signs of cooling, but we don’t think a steady downward trend has fully materialized yet.
Housing costs are an essential part of the economic backdrop. Higher market rents erode consumer spending and have a negative impact on discretionary spending including retail sales, which remains a significant part of the economic engine.
Chairman Powell expressed confidence that lower market rents would eventually translate into lower housing inflation. He did acknowledge uncertainty about the timing of this impact. He also stressed that any decision the Fed might make will be data dependent. We are of the opinion that this data point may cause additional complications for the Fed’s action to lower rates. We see these rate cuts potentially being pushed out further in the year and then being construed as a political, more than economic move.
See the most recent PCE (Personal Consumption Expenditure) chart below, which includes housing but not food and energy:
So Why Would The Federal Reserve Consider Lowering Rates in 2024.
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Market Gauge Full Outlook:
The Fed voted to hold the Fed Fund interest rates steady last week. In fact, they are staying on the track of reducing the Fed Fund rates and a majority of Committee members voted to reduce rates 3 times during 2024.
The Stock Market celebrated with the biggest positive returns in 2024 and the biggest one week since December, 2023.
Why would the Fed cut their overnight lending rate?
There are several important reasons that the Fed is willing to stay on track to reduce the Fed Funds rates from its current 5.25% – 5.50% to a target (based on the dot pattern) of 3 cuts down to 4.50% – 4.25%? Even without a significant reduction below the current annualized rate of inflation of 3% or better, the Fed is inclined to reduce rates and probably sooner due to the following reasons:
- Even if inflation climbed to 3.0% or more, the spread between short-term interest rates (1-5 years) at 4.6% and the rate of inflation is too wide. They would like to see short-term rates at or below the rate of inflation. Otherwise, monetary policy is too restrictive and borrowing costs for businesses as and home buyers is punitive.
- The Fed believes that the economy is decelerating (slowing down), and they would like to see interest rates less restrictive. While corporate earnings have been well above expectations, growing 3.5% or better since 3Q 2023, companies are beginning to conduct layoffs and gear up for a softening economy. The Fed is aware of this and wants to provide easier credit for the economy.
- If the Fed is going to normalize interest rate conditions, they need to do it long before the election in November so as not to look as if they are trying to interfere with the Election and any perceived advantage for one party over another.
- The Fed understands that higher interest rates are a material drag on current government debt. Higher interest rates are now responsible for over $1 trillion in finance charges to the Government, exceeding the total defense budget. This is unsustainable.
- Interest rates need to come down to bring down the rates offered at the Treasury auctions. Treasury Secretary Yellen has indicated they will suspend some Treasury auctions until such time that interest rates come down as the finance rates on these auctions are egregious.
A big week for Central Banks around the world.
Many countries around the world also held central bank meetings over the last few weeks signaling their future plans on their monetary policy.
The Swiss National Bank, citing progress on inflation, became the first among global peers to cut interest rates. Norway signaled no such move to lower rates for at least another 6 months. As was expected, The Bank of Japan finally ended its negative interest rate regime (-0.25%) and raised rates to 0%. This was a long time coming and a good sign that economic conditions have finally picked up in Japan.
In Africa, central banks in the continent’s biggest economies, including Egypt and Kenya, all maintained tight monetary policies to contend with lingering and sticky inflation.
Several other developed nations signaled optimism that their rate cuts were still on the table for later this year, similar to the United States stance.
The Fed’s Projections.
As referenced above, much of the Fed’s motivation for reducing the Fed Funds was that inflation would decline and economic conditions soften. Their longer-term expectations were evident in the data that they put forth this past week. See table below:
As mentioned above, it certainly seems that Powell & Company are willing to accept higher inflation (as referenced in the chart above) than previous targets.
Our take: Both Mish and I have been suggesting that inflation wouldn’t come down so quickly. While we both saw it trending down, we were not surprised that it started to pick up again in January and February when it unexpectedly came in “hotter” than expected. Right now, we are having a hard time buying the idea that inflation gets to 2.4% with economic conditions as good as they currently are.
Not everyone is happy with possible rate cuts.
We have maintained “higher for longer” and will continue with this narrative. Additionally, we are not surprised that some economists have NOT agreed with Chairman Powell’s assessment that rates should be reduced. Former Treasury Secretary Lawrence Summers this week accused the Fed of having “itchy fingers” on rate cuts in the face of a stronger economy.
In summary: We would NOT be surprised if the Fed went to 1 or 2 rate cuts and that they could be put off by a month or two than is currently expected.
Continued Concern:
For over a year we have laid out the lingering concerns from some economists that we are headed for a recession. This has not materialized (yet), even though we have had the longest running inversion between 2-year and 10-year Treasuries. In the past, this type of inversion has forecasted an oncoming recession. There are still plenty of market commentators who continue to stick with the recession narrative. See chart below:
We have no idea if a recession in 2024 will ever materialize. However, we remind you that in the past the Federal Reserve has cut rates more often from weak economic conditions. These were typically the result of slow or no growth or an economic contraction that was facing a recession.
Does the Federal Reserve know something that they are not telling us?
The Stock Market Surge.
Given the positive news from the Federal Reserve and no pushback from Chairman Powell, even with the recent climb higher from the CPI, PPI, and the PCE, Wall Street surged based on potential future rate cuts. Why?
Lowering interest rates provides less drag on companies and investors as financing rates decline. Long-term investors adjust their future cash flow rates to evaluate possible stock targets. Additionally, earnings can begin to re-accelerate as consumers feel the “ease” from lower interest rates. Calculations on stock multiples can expand as the looser financial conditions take over.
Investors and traders celebrated the news of these possible rate cuts and the S&P 500 closed above 5200. This marked the 20th new high for the year on Thursday.
The MSCI global gauge of shares also climbed more than 2% for this past week while the S&P 500 closed up 2.3% for the week, putting in its best week since December.
According to Eric Sterner at Apollon Wealth, “The Goldilocks narrative is still very much in play with the Fed sticking to its projection for cuts while also raising economic growth forecasts.”
Not only did the S&P 500 establish a new high but stock markets around the world, including Japan, Hong Kong and across Europe closed on new highs as the global stock market rally (bull market) continues.
Could the Federal Reserve cut rates with the S&P at new fresh highs? (it has happened more often than you might think-see chart below)
The Bull Market is Making History: 5 months, 28% and $10 Trillion.
Use the links below to continue reading about:
- How many new All Time Highs the S&P 500 has had already in 2024?
- What big cap stocks were the big winners last week (and which were the big losers)?
- How many weeks the NASDAQ 100 (QQQ) has gone without as much as a 2% drop?
- What sector of the market has doubled the S&P 500 and is still doing well?
- What is the current average household allocation to stocks? (this might surprise you)
- What the market is forecasting now that we are in an upcoming Election?
- The Big View bullets
- Keith’s weekly video analysis
- And more!
The market’s price action and news flow can be confusing and intimidating, but investing in this environment doesn’t have to be. If you would like personal guidance and hands-on management of your assets with the assistance of tactical, risk-managed, strategies, please contact me at [email protected] or Keith at [email protected].
The post Why would the Fed cut their overnight lending rate? appeared first on Southern Boating.
Source: https://southernboating.com/marketgauge/why-would-the-fed-cut-overnight-lending-rate
