If the Fed Has Any Credibility Left, it Won't Cut Rates at All
The Federal Reserve seems poised to make a token interest rate cut this week, but why now?
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The Federal Reserve is always supposed to be apolitical, but there is such a build-up going into this election cycle that one wonders if it can actually put its blinders on and do the right thing.
On Monday morning, we saw a letter from the U.S. Senate asking Chair Jerome Powell to cut rates by 75 BPS at the Fed's long awaiting September FOMC meeting this week. It is rather ironic that, in 2022 when inflation was averaging close to 9%, the senate never appealed to the Fed to raise rates by that much and instead, the Fed only raised by 25 BPS.
Today, the S&P 500 is close to all-time highs and house prices are increasing by 6.5%, yet they are debating between 25 BPS and 50 BPS. So, what is really going on? Why is everyone so desperate to get these cuts in and to do so now?
The U.S. presidential election will be held in November and the Fed already lost its tiny window to take action while maintaining an apolitical reputation. Given the comments it has made indicating that the labor market had cooled down to pre-COVID trends, and that inflation was returning close to its 2% goal, the fact that they are talking about cutting rates is noteworthy. It seems at odds with those comments, as inflation may have cooled down to 2.7% or so, though it is still up on a relative rate of change number, not to mention from the 40% changes over the last few years combined.
This is more of a token cut, as the Fed is doomed if they do and damned if they don’t. The obvious choice would be 25 BPS and to stay the course. That would be wise, as it would put the rest of Wall Street on their back foot, focusing on the data, rather than just chasing the charts blindly.
The U.S. market is a two-tier economy, whereby demand for manufacturing is horrendously weak and services are holding up quite well. If the Fed cuts rates to address the former, then inflation can get out of control. This is the longest time that the yield curve has remained inverted and today the 2/10-year curve is trading at a positive 8 BPS level.
This is the longest that it has stayed inverted without a recession. Financial conditions are loose, as can be seen by the credit markets. The U.S. consumer is weak as their post-COVID savings have run out and their credit cards are maxed out, not to mention that, no matter how much real wages tick higher, they are still underwater and unable to afford new homes. As rates get cut, that wealth inequality will get worse, asset prices will rally, only to then fizzle out yet again.
The issue today is that the bond markets are pricing in about 150 BPS of cuts in just one year. There is a huge disconnect between what the bond market is saying and what the Fed is hinting at. It has always paid to listen to the bond market, as it is the more sophisticated brethren amongst other asset classes. Ordinarily in the past, the tight rates would lead to a recession that would lead to a credit crisis, that made the Fed cut. Today, with markets at all-time highs, one wonders what their end goal is. With U.S. national debt close to $36 trillion, how much QE could the Fed possibly commit to save the economy during the next crisis (and there will be one, there is always one, it is inevitable)?
Regardless of the Fed's choice, one thing is clear. The bond market is overpriced here and is at risk of falling, taking yields higher and hurting equities. Markets cannot have it both ways: better economic data plus 150 BPS of cuts. It has to make a choice.
Something is not adding up. Brent oil has done a good job in coming down to $70 area and the Fed may want to rethink raising animal spirits as, once the inflation genie is out of the bottle , it will be even harder to put it back inside, especially when the U.S. consumer is yelping for help.
If it were really apolitical, the Fed should do nothing and then respond later as it has done in the past. It would certainly be better for its credibility, if there was anything left from last year at all.
At the time of publication, Bengali had no positions in any securities mentioned.
