The Fed Cuts Loose

The Fed Cuts Loose
Stéphane Renevier, CFA

2 months ago3 mins

What just happened?

This is the news investors were waiting for: the Federal Reserve (the Fed) has just let slip that it’s pretty much done hiking interest rates and might even cut them three times next year. The central bank’s decision-makers see rates dropping to about 4.6% in 2024, and as low as 3.5% in 2025 – far lower than the current 5.25% - 5.5%.

This has markets partying: stocks are raising the roof, with the Dow hitting a record and the S&P 500 not far behind. The drop in yields is sending bond prices soaring, especially among those rate-jumpy short-term Treasuries, which just had their best day since the whole Silicon Valley Bank fiasco. Gold’s up, world currencies are flexing against the dollar, and corporate bonds are rallying too.

What does it mean?

The Fed’s target interest rates are still where they were at the start of the week: the Fed held them at this 22-year high for a third time, as it winds up its battle against the country’s meddlesome inflation. But, with price rises falling more convincingly now, the central bankers are plotting some sharper cuts next year. They’re attempting to nail that dream “soft landing” – raising rates just enough to deter spending and bring inflation back to its sweet 2% target, but without crashing the economy or the job market.

And the Fed seems pretty pleased with its progress: inflation’s on its way down, the job market’s mostly in balance, and those past rate hikes are still working their magic. Now, the Fed can focus on making sure the economy doesn’t fall too far, and trigger a recession or mass job losses.

Bond investors are skeptical, to say the least. They had their doubts all along about the Fed’s “higher for longer” interest rate warnings. And now they’re doubling down, predicting not three rate cuts next year (like the Fed is suggesting), but seven. That would leave the central bank’s key rate just above 3.5% at the end of next year – nearly 2 percentage points lower than it sits now. That’s a way steeper fall than the Fed’s foreshadowing.

Why should you care?

Right now, it all seems like sunshine and rainbows: the economy appears to be inching closer to that dream, recession-avoiding “soft landing” scenario, and those lower interest rates should boost pretty much everything from your stock portfolio to your grandma’s bond collection. But, (yep, there’s always a “but”), by expecting much sharper cuts than the Fed’s laid out, the bond market is betting that inflation is about to drop sharply to its target. Since it’s unlikely to happen by itself, it’s probably hinting that something less rosy might be afoot – like, potentially recession-level less rosy.

And, look, the bond market may be wrong and the economy may stay strong. But, if that’s the case, those rate cuts might never happen – and that won’t exactly be great news for investors who are banking on them. What’s more, all this talk of lower interest rates could actually heat up the economy so much that inflation spikes again, bringing back the potential for more rate hikes. Talk about a plot twist...

Don’t get me wrong: these are good problems to have, and there’s a real chance the economy does achieve a soft landing. But there may still be quite a bit of turbulence left in this journey.



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