A note from Callie: It’s been an awesome two years of sharing my market & economic insights with all of you through The Bottom Line. I’m extremely grateful for the opportunity to connect with you and navigate these wild markets together.
This week’s edition is bittersweet, though. The time has come for me to move onto a new chapter. It’s my pleasure to introduce you to Bret Kenwell, eToro’s Options Analyst, who will be your new guide to breaking down markets and digesting what it all means for everyday investors.
I’m not disappearing, though. I’m forever a student of the markets alongside you. If you want to stay in touch and follow my market insights, you can find me on X @callieabost and on LinkedIn.
When it comes to the current rate cycle, there have been three basic stages.
First we had the rate-hiking stage, in which the Fed was forced to embark on a rapid rate-hiking spree due to inflation. This started in March 2022 and continued until the Fed’s last hike in July 2023.
Then we entered the second phase — the pause — in which rates stayed unchanged as the Fed waited for the economy and inflation to cool. We’ve been in this phase for about six months now.
However, investors are looking for the next phase of this cycle, which is the inevitable rate cut from the Fed now that the economy and inflation have cooled.
The question isn’t “if” the Fed will cut rates, it’s “when.”
March vs. May — does it really matter?
According to the bond market, forecasts for a March rate cut sit just under 50-50. A month ago, those odds sat near 75%. Now investors are trying to figure out the Fed’s next move.
Many factors have now aligned in the Fed’s favor to justify a March cut.
For instance, the PCE report — the Fed’s preferred inflation gauge — showed that core PCE is down to roughly 2% on a three-month and six-month annualized basis. However, in the Fed’s most recent meeting, Chair Powell said a March rate cut is unlikely because they need to feel more confident about inflation’s progress.
Whether the Fed cuts in March vs. May is sort of a moot point. The meetings are just six weeks apart and we’re only talking about 25 basis points (or 0.25%).
And according to current odds, the bond market’s only pricing in about a 12% chance that rates will be at current levels after the Fed’s May meeting. So either way, we’re likely getting a rate cut soon, it’s just a matter of timing.
While six weeks and 25 basis points aren’t a big deal, the concept is more significant, which is the idea that the Fed is officially embarking on a rate-cutting cycle. To investors, that’s an important next phase.
Impact of lower rates are here
We’ve already seen the impact of lower rates, while equity markets are higher and financial conditions have loosened significantly.
Only this easing has come in anticipation of the Fed’s next step, rather than the Fed actually cutting rates.
Further, bonds have been rallying, driving bond yields lower. That’s helped push down borrowing rates for commercial and consumer loans, many of which are tied to Treasury yields.
Think mortgage rates, car loans, and commercial lending.
How many rate cuts are we talking about?
Even though progress is being made on inflation, the Fed wants to be completely confident that it’s trending lower.
Nobody knows how long that’ll take, though. Not even Powell, despite his efforts to tamper down expectations for the March meeting. The bond market may be baking in about six rate cuts in 2024, but that’s been a moving target this year.
There may be some logic to grasp among all the indecision, though.
In January, Fed members estimated that the neutral policy rate – the level that neither restricts nor stimulates the economy – is 2.5%. You could also calculate neutral as the level of inflation plus an additional rate of 1.5% or so – about where real rates have stood historically.
Either way, now that inflation is down to 2%, a neutral rate isn’t a crazy thought. And we’re far from neutral, which implies several rate cuts could be in front of us. Again, it’s just a matter of when.
What could go wrong
Because the economy has been so strong, it’s given the Fed leeway in how long it takes to cut rates. Likely, they’d rather be a little late to the rate-cutting game than too early.
Put another way, the Fed desperately wants to avoid a situation where it cuts rates too soon and has to resort to a rate hike to balance things out. Plus, it’s easier for the Fed to cut rates if it’s behind the curve.
There’s a risk in waiting too long, too.
The longer rates stay above 5%, the more the Fed risks keeping the economy in an unnecessarily restrictive environment for too long. In that scenario, the risk of a recession will loom larger than the risk of spiking inflation.
Plus, we have the presidential election later this year, and the Fed will want to have its rate policy sorted out before the election cycle begins.
So what does this mean for me?
Stocks and bonds have already enjoyed a big rally over the past few months, while the S&P 500, Nasdaq, and Dow recently hit new record highs.
While the market may have pulled forward some of the gains investors might typically expect in a falling-rate environment, declining interest rates are generally favorable for stocks — particularly when the economy remains strong.
More specifically, interest-rate sensitive sectors and stocks could benefit.
For example, high-yield dividend stocks, real estate, and utilities rallied hard in the fourth quarter in anticipation of lower rates, but have been under pressure in 2024. When the path for the Fed’s rate hikes does become more clear, these groups could benefit.
Still, inflation data could be under a microscope going forward.
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*Data sourced through Bloomberg. Can be made available upon request.