The much anticipated Federal Reserve Board meeting on September 18th led to the first interest rate cut since the early days of the Covid pandemic.
The 0.50% cut to the Federal Funds Rate was larger than some anticipated and has many asking, “what comes next from the Fed?”
GOLDILOCKS AND THE THREE BEARS
I think the easiest way to think about the path of future rate cuts is to look at an old fairy tale we are all familiar with, “Goldilocks and the Three Bears”. After eating the porridge that is “too hot” and then eating the one that is “too cold,” Goldilocks finally settles on the porridge that is “just right.”
This concept of finding the amount that is just right, i.e. the “Goldilocks principle” has been used as an analogy in many different disciplines. In this case it applies perfectly to what the Federal Reserve Board is trying to accomplish with their current rate policy decisions.
On one hand, if the Fed cuts short term interest rates too slowly, it could lead to slower economic growth and higher unemployment. This would be the “too cool” scenario.
On the other hand, if the Fed cuts rates too quickly, the fear is it might lead to excessive risk taking at a time when economic growth is already strong. This in turn might cause a re-acceleration in core inflation, which is still running slightly above the Fed’s long term goal of 2%. This would be the “too hot” scenario.
THE “JUST RIGHT” SCENARIO
What the Fed is aiming for is the “just right” scenario where they are able to bring inflation back to their 2% target without causing high unemployment, and leading us into a recession.
So far, the economic indicators seem to be supporting the “Goldilocks” scenario as we’ve seen the inflation rate continue to come down, while the unemployment rate has only ticked up very modestly.
In response to this, we’ve seen the stock market rally back to all-time highs.
WHAT THE FED REALLY CONTROLS
What some are missing, though, is the Federal reserve board only controls policy on the short end of interest rates, while it’s the economy itself (and not the Fed) that drives longer term interest rates.
When the Fed cut rates, short term instruments like High-Yield Savings Accounts (HYSAs), CDs, and Money Market funds immediately responded with lower yields for savers and investors.
However, longer term bond rates, measured by 10-30 year treasury bonds, had already dropped significantly over the past year in anticipation of the Fed cuts. Meaning, the rate cut we saw in September was already priced into the financial markets and especially the bond markets.
The yields on longer term bonds actually responded by rising slightly, as the Fed signaled in their post meeting press conference, the pace of future rate cuts will largely be dependent on the economy. As we’ve mentioned before, the data on the economy and consumer spending especially remains strong, signaling the Fed may be more gradual with future rate cuts.
ADJUSTMENTS WE HAVE MADE
The response we took at Zizzi Investments over the past year(+) as we’ve seen signs of inflation cooling, has been gradually helping investors to dollar cost average out of cash and short term bond positions that were in excess of their emergency fund needs.
While we always advocate for keeping a healthy emergency fund in alignment with your overall financial plan, we’ve helped many people to reposition excess cash funds over the past 12-18 months into categories we feel will have a better longer term return potential.
For higher risk investors and those with a longer time horizon, this has largely meant continuing to dollar cost average into stocks.
For lower risk investors and those closer to retirement age, this has meant adding some intermediate/long term bonds and more rate sensitive equities into their portfolios.
As the Fed mentioned after their September meeting, the path of future rate cuts depends on economic data. We continue to monitor economic activity closely, and the signs at this time point to the possibility that the “Goldilocks” scenario can remain in effect.
So far, the financial markets have responded positively to the recent adjustments on Fed policy, which has outweighed any market jitters surrounding the upcoming election. We think now that the market has moved past the initial rate cut, corporate earnings will move back into the focus as the market gears up for Q3 earnings season.
