Even at 50bps, was the Fed cut just following the market?

Yesterday’s Fed cut was the first in this cutting cycle that might be described as unexpected, albeit marginally. Futures markets had priced in a roughly 62 per cent chance of a 50 basis point cut on Wednesday morning. Federal Reserve Chairman Jerome Powell’s cut of 0.50 per cent, therefore, was possible and probable, but not a certainty.

That is, unless you look at the bond market. Paul MacDonald, Chief Investment Officer and Portfolio Manager at Harvest ETFs, explains that longer dated yields had already factored in a significant reduction in Fed rates. US two year government bond yields, for example, area down around 1.5 per cent since April, with the expectation that the Fed brings its overnight rate down to around 3.25 per cent this time next year. While there may be some speculation that the Fed has still not moved fast enough, MacDonald believes this cut roughly aligns with bond market expectations. He adds that it also matches the expectations for a slowing US economy that is till headed for a soft landing.

“We’re in this transition from hiking to easing, and that's happened now,” MacDonald says. “I don't think that the trend is going to change, just given some of the leading indicators that we look at such as employment data and inflation. I don't want to dismiss the risk that things can change quickly, and that this can go from soft landing to a hard landing very easily, but for now, there's nothing that changes our view today.”

While some analysts had argued anything more than a 25 basis point cut implied unexpected weakness in the US economy, MacDonald doesn’t see things currently worsening beyond what indicators already show. The US economy is slowing down, unemployment is ticking up, and while things could turn worse it appears the world’s most important economy is headed only for a soft landing. Once the Fed rate hits around 3-3.25 per cent, he also expects the yield curve to normalize.

The only surprise MacDonald saw in this cut was the relative lack of political pushback. Noting that the election cycle is highly polarized, he was surprised that the cut has been so far greeted with minimal political noise. He emphasizes Chair Powell’s comments distancing his work from the political arena, placing the focus solely on the dual mandate of controlling inflation and unemployment.

The US cutting cycle should be, broadly speaking, a boon for markets and investors. At the same time, MacDonald expects that we will continue to see volatility. Markets will remain highly data-sensitive, in his view, which could cause more peaks and troughs going forward.

Lower borrowing costs, however, should be supportive of earnings growth across broader US equity markets. The mega-cap names in the Magnificent Seven had outperformed thanks to their dramatic rates of earnings growth, and have struggled more recently as those growth rates have slowed. Broader equities, however, have gone through around three quarters of negative earnings growth and are only now beginning to shift positive. Fed cuts, MacDonald says, should be supportive for that continued growth across the broader segment of equities.

MacDonald pushes back, too, against the focus solely on interest-rate sensitive sectors during this cutting cycle. While many sectors are more directly exposed to a cut, MacDonald argues that because markets are forward looking, that positive exposure has already been priced in. Utilities, for example, have performed roughly in line with the S&P 500 this year on the expectation that rates would come down. He expects that trend to continue, but notes that it isn’t beginning with the Fed’s decision to cut.

MacDonald continues to emphasize the value of US healthcare stocks as a source of ballast and argues that given the volatility we may see in fixed income now, covered call overlays on a fixed income allocation can help monetize some of that volatility.

Given the fact that the cut appears somewhat unexpected and that markets seem to have been waiting for a cut for years now, many advisors may be dealing with clients who have read banner headlines and want to change strategies entirely. MacDonald says that while advisors can talk about opportunities in this environment, they should temper them with the reasons behind the cut.

“Yes the Fed is cutting, but it’s really important for advisors and their clients to understand that a lot of it has already been priced into the market,” MacDonald says. “We have to be forward looking and focused on anything that changes the potential outlook for the economy and the markets. We don’t have that right now, but that’s something we should all be focused on.”