When you get an email regarding interest rates, I know that most non-financial people switch off and hit delete. But STOP! Bear with me, I think this brief 5-minute read will help give you a better grasp of why this stuff matters to you. Let’s break this down simply:
Being a father of two kids under the age of 3 makes me wonder who ever came up with the idea that taking candy from a baby was an easy task? Maybe my kids are the exception, but taking candy from my 2-year-old is not an activity that my wife or I enjoy. Being a parent however, means that sometimes you need to take action to protect your kids from what they think they want. In thinking about the Fed and the likelihood that they will cut rates this week, it makes me wonder whether they would have the fortitude to take the candy away in future?
First, when we speak about the Fed, we are speaking about the Federal Reserve, or more specifically, the Federal Open Market Committee (FOMC). The FOMC is headed by a gentleman named Jerome (“Jay”) Powell, which is why you probably see his name in headlines. He is the one that does the major press conferences and is responsible for communicating what the Fed is thinking.
The FOMC is in charge of setting the interest rate called the ‘Fed Funds Rate’. This is the target rate at which banks lend money to other banks, therefore playing a major role in the ‘cost of money’ in an economy. (An interest rate can be seen simply as the cost of borrowing money). When the Fed raises the Fed Funds Rate, generally it gets more expensive to borrow money, and when they lower rates, it gets cheaper.
So where are we now? Hasn’t the Fed been raising rates? Yes. During the midst of the 2008 financial crisis. The Fed dropped interest rates to almost zero. They did this thinking that if interest rates were very low, people would borrow more, spend more and therefore stimulate the economy. Since 2015, the Fed has been steadily raising rates as the economy has gained strength in the aftermath of 2008.
I can already hear you asking: “if low rates stimulate the economy and often lead to economic growth, why wouldn’t you just have low rates all the time?” Generally, if rates are too low for too long and an economy is doing very well, inflation starts to rise and can get out of control. In order to keep inflation under control, the Fed raises rates which restricts or slows down the economy. It is a delicate balancing act of trying to keep interest rates in a sweet spot that allows for strong economic growth, low unemployment and inflation that is under control.
Here is where it gets interesting. The stock and bond market are now expecting the Fed to cut (lower) rates at least 2-3 times this year. That is a significant turnaround from 6 months ago when the market was expecting 2-3 rate hikes (increases) this year. I recently attended a panel discussion in NYC with a group of top stock and bond investment managers. One of the bond experts that was on the panel said that in 35+ years in the business, he has never seen such a dramatic U-turn of expectations in a 6-month period. This is what we mean:
Take a look at this chart from December 31st 2018 (the beginning of this year). Don’t get caught up in the numbers, but note the red box on the far right highlighting 2 dotted lines. The blue dotted lines indicate the path that the FOMC (Fed) expects interest rates to follow. You can see that at the beginning of this year, the Fed was expecting to continue to increase interest rates (about 2-3 hikes this year). The brown dotted line below shows the expectation of where the market (investors) believed the path of interest rates should be. As you can see, investors were hoping that the Fed would stop raising rates this year, or at the very least, only raise once. This divergence of opinion played a big role in the correction in the stock market late last year.
Contrast that to how the outlook changed just 6-months later on June 30th
As you can see, both the Fed and the market are now expecting dramatic cuts to the level of interest rates over the coming year. This is where it all gets a little confusing. This dramatic swing has occurred during a period of time when employment, economic and earnings numbers are all pretty much unchanged from 6 months ago. The Fed has always prided itself on being ‘data dependent’. This essentially means that they make their decisions solely based on data, not outside influence. If they are truly data dependent, what are they seeing that has suddenly made them so skittish? Do they really believe that businesses and consumers are holding off making investments because rates are just too high? (I personally don’t know of any client or relative that is holding off on buying a house because mortgage rates are too high).
If not based on data, then why would the Fed be setting themselves up for potential cuts in the coming months? We think it is because they don’t want to take the candy away from the toddler (the markets) and risk a tantrum. The toddler has been promised candy, and they intend to collect it. (On a side note, my daughter can’t ever remember where she left her shoes, but her memory is unrivaled when it comes to recalling promises of candy and treats). The Fed has all but said that they are going to cut rates and the markets will react very negatively if this doesn’t happen. In a sense, the Fed has backed itself into a corner that it can’t easily escape.
This Wednesday (July 31st), the Fed will make their announcement and it is all but a foregone conclusion that the Fed will cut rates by 0.25%. Historically, when the Fed cuts once, they tend to cut about 3 times. This means that come the next recession, they will have very little firepower to lower rates further. Cutting rates at a time when the economy is generally doing well weakens their hand and reduces available tools when things do inevitably take a turn for the worse.
With a stock market that is priced in a way that suggests that there is no chance of taking the candy away, complacency remains investor’s biggest risk.
Contrary to the old saying, it is never an easy task to take candy from a baby. It remains to be seen whether the Fed will eventually take the short-term candy away for the longer-term health of the toddler, even at the risk of a tantrum.
- Darren J. Leader, CFA
Director of Research & Financial Planning
Brokerage and commission-based Securities offered through Purshe Kaplan Sterling Investments, Member FINRA/SIPC. Headquartered at 18 Corporate Woods Blvd., Albany, NY 12211. Investment Advice offered through Simmons Capital Group, a registered investment advisor and a separate entity from PKS Investments.
Purshe Kaplan Sterling Investments and Simmons Capital Group are not affiliated companies.