How Cautious To Be About Rates

What is happening?

This week the Fed will announce what many people expect to be an interest rate cut. This matters because the conventional expectation is that a cut in rates will lead to higher asset prices. Or in other words, that the market and share prices will rally. But it's not clear that this will actually happen.

Why does this matter and what are rates exactly? You've probably heard many people mention the Fed in memes or online - the Fed rate is literally just shorthand for the federal funds rate. It sets the interest rate at which commercial banks borrow reserves overnight. But for all practical applications, you can imagine that it just represents the general interest rate set.

Why does the interest rate matter? In short it is the price at which people can borrow money. So interest is like the price of money. And convention is that if you can borrow large amounts of money, then so can companies. Companies can then take that and invest in their operations - which usually also leads to higher company valuations. This is because they have more cash on hand, more investment potential, and general ability to expand operations - all of which theoretically lead to a greater expected cashflow, which then leads to a higher share price. This is super simplified but you get the gist.

So people expect that the rate cuts will lead to a market rally, but of course there are more nuances at play. In short, it's not clear that a rate cut will lead to a rally because of first, the context of sticking what is called a 'soft landing', and second, the actual economics of firms experiencing interest payments may be lagging the announcement.

In summary, the Fed is trying to lower rates to boost economic activity while still controlling inflation. This is called a 'soft landing'. The danger is that lowering rates might lead to inflation rising again - and then the Fed might need to keep rates high, which in doing so might just worsen the economy. That's called the 'hard landing'. So the issue is how to keep inflation under control without triggering a recession.

A soft landing is when a central bank—such as the Fed in the U.S., the European Central Bank or the Bank of Japan—is able to bring inflation down and cool a hot economy without setting off a significant decline in economic activity, also known as a recession
(source: https://www.wsj.com/podcasts/the-journal/why-a-soft-landing-for-the-economy-could-be-hard/94ef99e7-a7e1-40aa-ac0e-53653567a7a9)

Enter now: inflation was relatively high post-covid and so rates have been fairly elevated at an incredibly fast pace. That was why we witnessed some phenomena like the Yen being relatively weak and some rapid currency fluctuations. They were a result of some disparities between the US interest rate and foreign rates.

And a quick aside on why controlling for inflation matters: It's basically the mandate of the Fed to control inflation; and inflation is bad because it tends to reduce the real income of consumers, distort the economy, and lead to weaken economic activity. These effects are generally very large and undermine the structure of the economy. And so inflation is taken seriously as something to control, which the Fed targets to be at 2%.

Now back to our current day, it seems that inflation is under control and so the Fed has some slack to begin cutting rates. Inflation is currently at 2.5% as compared to July's 2.9% and 9.1% in 2022, as NYT reports (source: https://www.nytimes.com/live/2024/09/11/business/cpi-inflation-fed). This also seems pertinent since the labour market is showing some signs of weakness.

Why does it matter?

So then the pertinent questions are:

1. How much will the Fed cut rates by, if they do?
2. How much will such a rate cut translate to a market rally?

For the first question, it seems apparent that the Fed will cut rates. More precisely, the distinction is between a cut of 0.25%, or 25 basis points, or 0.50%. The latter is more aggressive and will be a bigger move. Consensus expects the more conservative 0.25% cut.

Either way, after confirming the cut, the real question will be about forecasting how aggressive the Fed plans to act in the coming months.

This has deeper implications for traders and investors who need to forecast the path of rate cuts; but as far as retail investors are concerned, I think that the general worry is if the rate cuts lead back to inflation rising again.

So we're back to the predictions of whether it will be a 'soft' or 'hard' landing. If it's a soft landing, then the economy is relatively unscathed and positioning could be more aggressive in the market. If it's a hard landing then it means a recession and the worry is we should be more conservative with our portfolio positioning i.e. be cautious about equity stakes and look to securities which insulate from market downturns.

Interestingly, the Fed has only once really stuck a soft landing, which happened in the 1990s. I'm not sure that serves as strong evidence that a soft landing is unlikely but it makes me more conservative in evaluating a possible rally.

Another point is that most of the recent inflation was driven by supply factors, at least in the beginning of the pandemic. This means higher prices were driven by a lack of production of goods due to supply chain constraints. This makes intuitive sense when you recall that the pandemic was also about shutting down transportation and created backlogs in manufacturing. Recently, inflation was also driven by the demand-side, but I think that smoother supply lines can at least assuage the risk of inflation resurging even when rates are cut. (source: https://www.chicagobooth.edu/review/whats-causing-inflation-supply-demand)

Economic performance seems set to continue in a healthy manner for several reasons. First, the magazine The Economist suggests that modern economies are simply less sensitive to interest rates. If a firm requires less capital investment, then they need to take out less debt and are thus less affected by interest rate changes. Think of the difference between a lightweight software company compared to a construction company with heavy equipment.

On the consumer's end, locking in fixed rates on mortgages and stimulus spending in the years prior have led to two effects. First, a fixed rate means recent high rates did not affect consumers much. Second, stimulus spending contributed to savings which insulated people from higher debt burdens. (source: https://www.economist.com/finance-and-economics/2024/08/29/inflation-is-down-and-a-recession-is-unlikely-what-went-right)

A fun piece of evidence to support this view is that credit-card spending in rich nations remains strong.

All in all, I'd err on a 7 out of 10 rating of confidence that there will be a soft landing. In other words, if I had a hundred dollars, I'd place $70 on a bet that there will be a soft landing. This is obviously not the same as declaring outright that this will happen for sure.

So if there's going to be a soft landing, then will a market rally follow? Unfortunately, I think for the same reasons that there will be a soft landing, I also think that a market rally will not necessarily follow.

The view is that firms actually have been insulated from the rate hikes to date. And so even though the rates are being cut now, comparatively firms won't benefit as much because they were already insulated. In fact, they enjoyed such low borrowing costs through a lock-in of long term rates from 2020 that it seems that once these rates start to expire in the coming two years firms will face higher borrowing costs.

More than $2.5trn—an amount equivalent to 9% of American GDP—of fixed-term corporate loans are due to be refinanced before the end of 2027, with $700bn due in 2025 and more than $1trn in 2026. The sectors most exposed to refinancing risk are those that benefited the most from cheap fixed deals immediately after the pandemic struck, notably manufacturers. (source: https://www.economist.com/finance-and-economics/2024/09/11/strangely-americas-companies-will-soon-face-higher-interest-rates)

To explain why, American firms went into the rate-hike period with large holdings of cash. This meant that higher interest rates also raised returns on cash itself. If refinanced, loans will hold a rate around 6%, above the median rate of 3.8% enjoyed so far. This creates the interesting phenomenon of rising servicing costs occurring just as interest rates are falling.

In other words, positive performance might have been front-loaded.

To bring it together, there are two things happening. First is the idea that there will be, on balance, a soft landing. So there won't be a recession or market downturn and that the Fed will be able to maintain lower rates. Second is the idea that there won't be much of a market rally, at least in the immediate short term. A key reason is because of the debt structure of most firms.

What does this mean for our views? Besides the above opinions on the market, I think that this implies a position of careful evaluation between quality equities. While there might not be an immediate improvement in the short term, I do think there's a chance for long term recovery in the coming years. That means there's still time to evaluate which firms will best grow in the coming cycle of rate cuts. As the rate cuts continue and the interest rate changes take root, there would be further adjustments in the long run.

Basically, this means now is the time to evaluate and deploy cash into some equities that may outperform in the coming cycle. I wouldn't be so hasty as to think there is a broad growth entirely - but neither do I think we will hit a recession in the immediate future. This is at least helpful for narrowing our focus on where opportunities might lie.