The Fed’s Rate Cuts: Anticipation vs. Reality
For the past two and a half years, investors have eagerly awaited a pivotal moment in U.S. monetary policy: the Federal Reserve's long anticipated interest rate cuts. This period has been marked by the Fed’s most aggressive rate hikes since the 1980s, creating a climate of speculation and hope for a shift in policy. As the Fed’s rate-setting committee meets on September 18th, expectations are almost 100% that Jerome Powell, the Fed Chair, will announce the first rate cut. Traders are debating not whether, but by how much the Fed will lower its policy rate, currently set between 5.25% and 5.5%. The market, according to the CME FedWatch tool, expects a 35% chance of a 0.25 percentage point reduction and a 65% chance of a more substantial 0.5 percentage point cut.
Historically, such rate cuts have often been seen as a boon for investors. The stock market, in particular, has typically surged on hints of lower borrowing costs. However, the adage “buy the rumor, sell the fact” suggests that while rate cuts can generate initial excitement, the actual outcomes can sometimes fall short of expectations.
Reviewing past rate cut cycles provides some insight into this phenomenon. During the 1990s, when Alan Greenspan led the Fed, successive rate reductions did bolster the stock market. However, the early 2000s saw a different story. The rate cuts at the start of the millennium coincided with the burst of the dotcom bubble, and subsequent cuts in 2007 were overshadowed by the global financial crisis. Even the dovish shift of 2019, which initially buoyed share prices, was ultimately overwhelmed by the onset of the COVID-19 pandemic.
The Complexities: Expectations, Timing, and Market Impact
The rationale behind rate cuts is straightforward: lowering borrowing costs can enhance corporate profitability and boost consumer spending. Additionally, falling bond yields make equities more attractive by comparison, potentially lifting stock prices. Yet, these benefits can be offset by various factors.
One enduring concern is that rate cuts are typically enacted in response to economic weakness. Although the current economic landscape is not as dire as in past downturns, there are signs of a cooling labor market, which briefly alarmed investors this summer. However, the economy appears to be slowing rather than heading into a recession, suggesting that corporate profits—and stock prices—may be somewhat insulated as the Fed begins its rate reductions.
A significant complication is the “long and variable lags” in monetary policy. Milton Friedman highlighted how the effects of rate changes can take time to filter through to the economy. Firms with fixed-rate debt, which benefited from lower rates in the past, may still face rising debt-servicing costs as they refinance. Similarly, homeowners with fixed-rate mortgages who need to refinance will encounter higher rates. As a result, the immediate impact of rate cuts may be less pronounced than in previous cycles.
Another factor to consider is the extent of market expectations. Traders already anticipate 1.25 percentage points’ worth of cuts by the end of the year and another 1.25 points next year. Such rapid reductions are typically associated with recessions or financial crises. This high expectation leaves room for potential surprises if the Fed takes a more cautious approach, which could lead to higher bond yields and dampen stock market enthusiasm.
The Value of Diversification: Balancing Risk with Bonds
The principle of diversification, famously encapsulated by Harry Markowitz, posits that spreading investments across various assets can achieve the same returns as a concentrated portfolio but with reduced risk. While this concept won Markowitz a Nobel Prize in Economics, practical application often reveals that diversification can sometimes feel like a drag on performance.
In theory, diversification allows investors to lower risk without sacrificing returns. However, the primary alternative to stocks—bonds—often offers lower yields. For those chasing high returns, this trade-off may seem unappealing. Nevertheless, recent market dynamics have highlighted the benefits of diversification.
Over the past few months, bondholders have seen gains even as stock prices fluctuated. For instance, an investment split between the Nasdaq 100 ETF (QQQ) and the Treasury bond ETF (TLT) would have seen tech stocks outperforming bonds in early 2023. However, as of mid-July, the Nasdaq declined by 7%, while the TLT fund’s Treasuries rose by 9%. This shift underscores the value of bonds as a stabilizing force in a portfolio, particularly when stock markets face turbulence.
Bonds typically perform well when stocks decline, partly due to their safer status in economic downturns. During market stress, bond yields tend to fall as investors anticipate central banks cutting rates, which boosts bond prices. This pattern was evident in August when a broader market panic over stock valuations increased the appeal of sovereign debt.
Caution Ahead
Despite the current positive performance of bonds, investors should remain cautious. Much of the good news may already be factored into bond prices, with the market expecting rapid rate cuts from the Fed. If the Fed's actions do not meet these high expectations, bond yields could rise, causing bond prices to fall.
Additionally, a surge in borrowing by companies indicates a rush to issue debt before rates potentially rise. This borrowing spree suggests that if rates do go up, the bond market might face challenges, potentially disappointing current investors.
Japan’s Monetary Policy: A Cautionary Tale
Japan’s monetary policy offers a stark contrast to the U.S. experience. In the 1990s, Tokyo was a city that seemed to embody the future, a vision that now appears frozen in time. The Bank of Japan (BoJ) was an early adopter of zero interest rates and asset purchases, a decade before other central banks. However, Japan's current monetary policy is notably stagnant. The BoJ’s asset purchases remain at record levels, with plans to continue buying assets worth ¥2.9 trillion ($20 billion) per month until 2026. This contrasts sharply with the Fed’s recent efforts to reduce its asset holdings.
Japan’s prolonged bond-buying spree has led to a distorted bond market. The BoJ now owns more than half of Japan’s government bonds, significantly impacting market liquidity. As a result, private sector bond ownership has plummeted, and bond traders frequently cite market inefficiencies.
Efforts to revive the bond market face challenges. With yields currently around 0.9%, a rise to more attractive levels would potentially increase investor interest. However, higher yields would also raise Japan’s government debt servicing costs, creating a political dilemma. A significant increase in interest payments could strain the government’s budget, necessitating spending cuts or tax increases.
The BoJ’s cautious approach to withdrawing from its bond-buying program reflects a balancing act between stimulating the economy and maintaining fiscal stability. Japan’s experience serves as a cautionary tale, highlighting the complexities of monetary policy and the challenges of adapting to changing economic conditions.
Comments