Fed's Upcoming Rate Cuts Won't Save a Recession

From the fall of 2022 through today, since ChatGPT launched its AI discovery, money kept pouring into the large-cap technology names as they spent trillions in capex to capture the next wave of generative AI productivity.

This massive surge has seen the Nasdaq move up by 70% and S&P 500 by about 40% in a straight line with very small curveballs along the way. This AI discovery has masked the true underlying weakness following the Fed’s most aggressive rate rise campaign in 2022 that cause several U.S. regional banks to collapse. Most had expected a recession at the beginning of 2023, which almost hit, but the Fed was nimble enough to inject trillions of liquidity through backdoor vehicles to keep the ailing financial system chugging along.

Doing QT and keeping rates at 5% or more, higher for longer, means the real economy suffered big time and slowed it down post the excessed of the post-COVID world. But, on the other hand, handing out free candy to banks allowed them to move their held-to-maturity assets (more like "hid-to-maturity"), marked at par, with no repercussions whatsoever.

This created a bifurcated economy and market, whereby all stocks and sectors exposed to the real economy and consumer kept underperforming, and only a handful of large-cap stocks like the Magnificent 7 kept shooting higher with the likes of NVDA being the only company with the first-mover advantage to ship all of their chips to these large caps that were chasing each other to get the most so they could stay ahead.

After all of this talk of AI changing profitability and company margins, getting drunk on the AI Kool-Aid, investors are now more sanguine about the investment prospects. Other than make a few mundane tasks much more efficient — but, as Goldman says, at six-times the price — it has not really helped any company boost its earnings or margins, yet. So, the proof is in the pudding and investors are eager. This increase in large caps has made the S&P 500 completely disconnected from the broader economy that is seeing higher delinquencies, consumers strained and commodities collapse as demand continues to be weak.

The Fed put has been truly alive and well since last year, which is why the market never manages to fall as they know the Fed will cut rates when need be. But it’s not about Fed cutting rates, it depends "when" they do it. Earlier this year, when growth was solid and unemployment below 4%, the Fed put was seen as stimulative. It was seen as a goldilocks market, i.e., stable growth and lower inflation. But waiting for the unemployment market to tick higher, as we have seen it go from 3.7% to 4.1%, it is already too late.

We have often opined that the U.S. economy is like a large cruise liner, that takes time to turn once you steer in a direction. Just because you don’t see the effect and you keep going, it will only be a matter of when, not if, you will realize you have moved off course entirely. But today, most U.S. indicators are screaming recession — the U.S. labor market has been showing signs of cracking for months and goods sector has been unable to keep up its bounce, taking the infallible services down together with it too. There is zero margin of error for any hint of a slowdown or mistake in monetary policy. And all at a time when everyone is all in and long the only market they know, the S&P 500.

There is an age-old adage: "When the Fed panics, the market panics more." This is where we are today, as the Fed will panic and cut in September, as it may need to, but it will be too late. Markets never bottom at the first cut, like in 2000, they bottomed a year later after several hikes. Most are long markets willing to look past any short-term hiccup as the Fed will change all.

But rate cuts do not mean the end to a recession. In fact, it is when the markets fall the most, as the downside inertia has already started. We know Bidenomics has played a huge role in delaying, or rather masking, the underlying weakness, given the massive debt spend. But even that is coming to a halt now. Other than the Fed embarking on another round of QE, when debt to GDP is already close to post World War II highs, there is little hope of a recovery, especially when no risk is priced in for U.S. elections nor U.S. fiscal or monetary policy uncertainty going forward.

All the while, every single sell-side analysts is pricing in a magical, V-shaped boom from China to save global demand. What could possibly not go wrong, we wonder.

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At the time of publication, Bengali had no positions in any securities mentioned.