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The Knight in Shining Armor: What’s Next for the Federal Reserve?

For the first time in 10 years, the Federal Reserve (Fed) executed an interest rate reduction.

The recent cut was widely anticipated by experts and markets, as the Fed has been transparent in its intentions. The Fed has become the knight in shining armor, pushing risk-based assets higher. The S&P 500 posted a 18.5% gain in the first half of 2019, partly due to the anticipation of lower interest rates.

What’s next? Will the Fed continue to be the knight in shining armor? We believe the Fed executed a preemptive move when dropping short-term rates from 2.50% to 2.25%. (They also ended the “tapering” of the Fed’s balance sheet, which helps keep rates lower). As their comments clearly outlined, they do not feel the economy is on the brink of a major slowdown and they are not reacting to contracting economic activity. Economic growth is moderating; however, we are forecasting 2.5% real GDP growth in 2019, which means the economy is still expanding nicely. And we expect economic momentum to continue into the first half of 2020. Additionally, inflation seems to be stuck below 2.0%. The path was clear for the Fed to begin unwinding the last two rate increases they implemented late last year as a proactive insurance policy to help keep the economy on a steady growth trajectory.  

The Fed believes slightly lower interest rates could help extend the current expansion by offsetting some of the global economic softness and political uncertainty dominating the headlines. The Fed made it clear that a second move lower is possible in the next few quarters if inflation remains tame. This will be similar to the preemptive easing moves the Fed executed during the long expansion in the 1990s. Their mid-cycle moves helped extend the expansion of the economy and markets for several more years.Fed Fund rate trends

The U.S. economy remains in a modest growth mode. Numerous economic data points indicate there is no recession on the foreseeable horizon (12-24 months out). Three key factors we view in tandem are telling us the economic expansion has room to run:

  • The Slope of the Yield Curve – this critical measure of the difference between two-year and 10-year treasury rates has inverted (10-year below two-year) well in advance of every recession in U.S. history. The slope recently inverted momentarily, and history tells us the inversion needs to be sustained for several weeks before it becomes a recession signal.
  • The Leading Economic Indicator (LEI) Index – the 6-month rate of change for the LEI has dropped to minus 3 at or before the onset of every U.S. recession in the last several decades. The current reading is +.50, well above the -3.00 figure that waves a red flag on growth. It is not at all uncommon for the LEI to drop to zero many times during an expansion, so the current reading is nowhere near a warning signal.
  • Jobless Claims – this variable has spiked above 300,000 in advance of every recession in recent decades. Currently, jobless claims are incredibly low – grinding their way steadily down to a recent average of only 213,000, the lowest reading in nearly 50 years.

Given an ongoing expansion and a preemptive move from the FOMC, what does that mean for the markets?

First, we must address Fed messaging, because in today’s environment, comments from the Fed and its guidance on interest rates will create volatility in risk-based assets. Fed Chairman Powell is in the early stages of learning how to handle this responsibility. At times, his comments are unclear and have been received poorly by the markets. Markets are negatively impacted by uncertainty and it often takes the markets several days to digest Fed statements. We experienced an initial spike in volatility and rapid selloff in response to the comments delivered with this first rate cut. We believe the markets will ultimately conclude that the Fed intends to execute enough mid-cycle cuts to ensure a prolonged expansion. 

When the Fed cuts rates preemptively as an insurance policy, being proactive as economic growth remains resilient, the stock market performs well. This happened in 1980, 1995 and 1998. The graph below demonstrates the average behavior of the S&P 500 before and after the first rate cut.

Average return for S&P 500

The Conclusion

We think lower rates from the Fed this year should be viewed as preemptive and will support healthy equity returns. After the cut to 2.25% in July, we think the Fed will continue to lower rates throughout the second half of the year. We expect the Fed Funds rate to end the year at 1.75%, and the S&P 500 to post 12-16% total returns in 2019. This should keep interest rates low, across the yield curve, for the foreseeable future (great mortgage rates), boost consumer confidence, bolster economic activity and help support reasonable equity returns well into 2020.

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