Last week at an economic symposium in Jackson Hole, WY, Federal Reserve Chairman Jerome Powell stated, “The time has come.” He was referring to the long-awaited interest rate cuts. It has been over four and half years since COVID-19’s arrival, inflation has declined drastically, the supply chain has normalized, and the labor market is finally softening. Investors will gladly agree, the time has come.
Before we dive into the affects rate cuts may have on your financial plan, it is important to understand where we came from, where we are now, and where we are heading. The personal consumption expenditures (PCE), which is the Fed’s preferred measure of inflation as it excludes food and energy, was 12.9% in 2021. This came on the back of enormous fiscal stimulus by Congress during and immediately after the COVID pandemic creating high demand and spending, mixed with a labor supply shortage as people left the workforce and energy and manufacturing supply chain issues. The Fed hinted in 2022 that to rein in such high inflation, a recession and increased unemployment might be necessary. The Fed raised their policy rate by 5.25% (525 basis) points from 2022 through 2023, where it has stayed since July 2023.
The latest PCE reading for July 2024 was 2.5%, closing in on the Fed’s target of 2%. Unemployment is now 4.3%, a full percentage point higher than last year, but still a historically low rate. Many economists are still perplexed by how inflation fell so quickly without crushing the labor market. It appears the reversal of shocks to energy and commodity markets had an outsized effect on disinflation and labor demand moderated which prevented mass layoffs.
While we are in an election year, and both sides of the aisle will continue to blame inflation entirely on the other side, it is worth remembering that the Trump and Biden administrations both flooded the economy with cash through stimulus bills. The Trump administration backed the March 2020 CARES Act and December 2020 Consolidated Appropriations Act, and Biden backed the March 2021 American Rescue Plan Act. Conversely, campaign ads continue to tout disinflation progress, but the Fed could probably take more credit for disinflation via their aggressive rate hikes and shrinking their balance sheet. Elections and their impact on the markets is a topic for another day, and as history generally shows, it ends up being less meaningful than monetary policy. Hence, let us stick to the potential rate cuts at hand.
When the Fed’s policymakers meet on September 17-18, they are expected to cut interest rates by either 0.25% or 0.50% (25 basis points or 50 basis points). So, what does this mean to your money?
- Stock Investors
Historically speaking, when the Fed raises interest rates, what is considered restrictive or tightening monetary policy, the stock market drops in the near term. The stock market is a leading economic indicator based on countless factors, but one of the most important is liquidity, and when the Fed restricts liquidity, investors feel it (see years such as 2022). Conversely, when the Fed cuts rates, what is called expansionary policy, the stock market tends to rise in the near term (see years such as 2021, 2020, 2009, or 2003).However, aside from the technical aspect of the markets, there is an emotional element too. If the Fed cuts rates 0.50% later this month instead of 0.25%, there is a chance the markets could react negatively if investors perceive fear on the part of the Fed about a potential recession with falling GDP or rising unemployment. The stock market is fickle and as a leading indicator, investors must factor in how much of 2024’s rally has already priced in rate cuts and what might be the underlying rationale for rate cuts.
Amid “soft landings”, when interest rate cuts coincide with no recession, large-cap stocks perform well, almost twice as well as small-caps. During “hard landings”, interest rate cuts amid a recession, international equities and commodities have suffered the worst, while U.S. large-caps fared better.
- Fixed Income Investors
Bondholders are familiar with the old “seesaw” analogy, an inverse relationship in that when rates fall bond prices rise, and when rates rise bond prices fall. As such, if the Fed cuts rates quickly, existing bonds and fixed income funds that purchased bonds over the past couple of years can become more valuable. But then there is a concern for bond investors moving forward in reinvestment risk. Someone who bought a 2-Year Treasury or CD last year at 5% could look at reinvesting that in a similar bond in 2025 at 2% or 3%, possibly lower depending on the size of rate cuts. These moves are important to cash investors, such as those sitting in high-yield savings accounts, as they can change their rates at any time. - Annuity Investors
The connection between annuity options and interest rates follows a similar analysis as it does for fixed income above. Investors looking to lock in higher rates for longer would be wise to secure longer-term fixed annuities before rate cuts versus after them when issuing rates have dropped. Investors purchasing annuities with a shorter-term may face the same reinvestment risk outlined above.In the variable annuity and indexed annuity space, which can involve many more factors, annuities traditionally offer higher performance caps and distribution rates when purchased in a higher interest rate environment.
In conclusion, the markets usually benefit from an interest rate cutting cycle as it lowers the costs of borrowing and doing business, creating a more liquid economy. This does come with the caveat that rate cuts are being done for positive reasons (i.e. inflation is under control) and not negative reasons (i.e. concern for rising unemployment or an attempt at jolting slow GDP growth). Conversely, people who have enjoyed “sitting on the sidelines” in cash accounts earning 4% or 5% recently may not be as happy.
The Fed and their fiscal policy has a tremendous impact on investing and financial planning, but it is not the only factor. As such, the disclaimer that past performance does not guarantee future results is critical. Please consult with your financial advisor to discuss your own situation and investment goals and risk tolerance.
Written by Bryan Kuderna.
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