Powell Signals Rate Cuts Are Coming – How Will The Market Respond?

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Forbes Article Link: Powell Signals Rate Cuts Are Coming – How Will The Market Respond?

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In a pivotal, long-anticipated moment, Federal Reserve Chairman Jerome Powell made a groundbreaking statement at last week’s Jackson Hole Economic Symposium: "The time has come for policy to adjust. The direction of travel is clear.”

This declaration marks a significant shift in the Fed's monetary policy stance, potentially ushering in a new cycle of interest rate cuts. But what does this mean for the stock market, and how should investors interpret this development?

Powell's remarks indicate a clear pivot in the Fed's focus from inflation to employment. While inflation has been trending downward towards the 2% target rate, the labor market has shown signs of significant deceleration. This shift in priorities suggests that the Fed is now more concerned about maintaining a robust job market than continuing to fight inflation aggressively.

Many investors have been waiting for this moment, hoping for interest rate cuts to begin as early as September 18th. Powell's statement suggests that looser financial conditions may indeed be on the horizon, aimed at slowing the deterioration in the job market.

The Fed's Timing

There's been growing concern among investors that the Fed has been too slow to cut rates as inflation has rapidly declined. This echoes similar criticisms from 2022 when many felt the Fed was behind the curve in raising rates to combat rising inflation.

In an interview with PBSInvesco Dynamic Media ETF News Hour, Allianz Chief Economic Adviser Mohamed El-Erian said, “They called inflation transitory, when it was something much worse than that, and, therefore, they were slow in moving against inflation. And now I fear that they are slow in moving against economic weakness. So if they're not careful, they will end up making both mistakes in one cycle.”

The slowing employment growth numbers have been cited as the primary evidence that the Fed is once again lagging behind economic realities. Reacting to the July employment report, which featured unemployment reaching a three-year high of 4.3%, Boston College economics professor told Reuters, “If Fed officials had seen this report, they would have cut rates by 25 basis points this week.” He went on to explain, “There is absolutely no justification for continuing to exert an elevated level of monetary restrictiveness on the economy.”

Market Reaction

The bond market has already been pricing in these anticipated rate cuts. Yields on longer-dated treasuries have declined significantly, reflecting the expectation of changes in interest rate policy. Now that Powell has clearly signaled the Fed's intentions, bonds seem to be aggressively priced. But what about stocks?

Many analysts have expressed concerns that rate cuts may be negative for stocks. This worry stems largely from recency bias, as the last three rate cut cycles resulted in significant losses in the stock market.

However, looking back to 1954, there have been 13 major rate-cutting cycles. Contrary to recent rate cut cycles, 10 out of these 13 cycles have been positive for stocks, with only two being very negative. The tech bubble crash in the early 2000s and the financial crisis culminating in 2007 through 2008 were outliers, not the norm.

S&P 500 Performance During Rate Cut Cycles

Even more encouraging is that the 12 months following the last rate cut produced significantly positive stock market returns after all 13 rate cut cycles concluded. This historical data suggests that the current concerns about rate cuts negatively impacting stocks may indeed be overblown.

Unlike the tech crash and financial crisis, today's economic landscape is quite different. There's no specific event triggering panic in the markets, and there are no clear signs of an imminent recession or developing economic crisis. The Fed's decision seems to be a proactive measure in response to slightly weaker employment numbers, rather than a reaction to a market panic or significant economic event.

However, one similarity to the tech crash era is the extremely high valuations, especially in tech-related companies. The S&P 500 is highly concentrated in the top 10 largest companies, reminiscent of the dot-com bubble. This concentration could pose a risk if investor sentiment towards AI changes or if these top companies' earnings significantly deteriorate.

Economic Impact

One of the most striking aspects of the current economic situation is the robustness of the U.S. economy. This strength can be attributed, in large part, to massive government spending programs that originated during the Covid response. These multi-trillion dollar, decade-long initiatives are likely to continue stimulating the economy for years to come.

As interest rates come down, there's a possibility that the government deficit may decrease significantly due to lower debt service costs. This dynamic could be received positively by the stock market, potentially offsetting any negative sentiment around rate cuts.

While it's natural for investors to feel apprehensive about upcoming rate cuts, historical data suggests that there's no need to panic. Rate-cutting cycles have almost always been very positive for the stock market. However, investors should be prepared for increased volatility as the market processes these changes and closely monitor inflation, economic growth and employment data.

The most significant medium-term risk to the stock market appears to be the heavy dependence on the top 10 companies in the S&P 500 to drive market returns, rather than the rate cuts themselves. There's also the potential for rate cuts to result in higher inflation again, which could complicate the economic picture.

In the absence of an emerging economic crisis or developing recession, the outlook for stocks remains cautiously optimistic. The Fed's shift towards a more accommodative stance, coupled with the underlying strength of the U.S. economy, provides a solid foundation for the continuation of market growth.