The Independent Market Observer

Fed Set to Cut Rates for the First Time Since 2008: Hooray?

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Jul 30, 2019 2:45:03 PM

and tagged Commentary

Leave a comment

FedThere has been a great deal of coverage about the expected rate cut by the FOMC at its regular meeting this week. Markets are counting on a cut of 25 bps (one-quarter percentage point), which has pretty much been confirmed by the Fed. There is even some betting that the cut will be twice as much. In any case, this move has been widely cheered as a necessary precaution—an “insurance cut” in the jargon—to prevent an economic slowdown from turning into something worse. If we step back and look at the big picture, though, there is less to cheer about.

Sign of trouble ahead?

Looking at the past 35 years, there have been few cases where the Fed stopped with one cut. More, a series of cuts has often been a leading indicator of a pending recession, especially for 1989, 2000, and 2008. In these cases, off a peak in rates, the start of cuts meant that the Fed saw a recession coming. Further, a recession usually showed up within a year or so, with the Fed cutting rates or keeping them low throughout the recession and the start of the recovery. But this scenario wasn’t always true. In two instances, the Fed got it right: in the mid-1980s and early 1990s, rates were cut and a recession was averted.

Fed

So, there is precedent for insurance cuts. But even there, the Fed doesn’t stop at one. In both the mid-1980s and early 1990s, there was substantial economic turbulence, although we avoided a formal recession. Overall, the lesson remains that if the Fed is worried enough to start cutting rates, there is a better than 50 percent chance of a recession. Even if that is avoided, there is still very likely trouble ahead. So, I am not going to cheer too much about the rate cut—and will cheer even less if we get a cut of 50 bps.

Less room to cut

Another concern I have is where we are starting to cut. There is a sense that rates never did normalize after the 2008 crisis. Looking at the chart above, you can see the size of the gap. The Fed funds target rate was 5 percent or above in the mid-1990s, and it recovered to that level in the mid-2000s. Since then, we have had even larger cuts. But during the (much longer) recovery this decade, rates never got close to that level, peaking at the current rate of 2.25 percent to 2.50 percent. Rates are nowhere near where they were prior to the last recessions. Because of that, the Fed simply has less room to cut.

Given the starting point, a 25 bp cut will exhaust a big part of the ammunition. A 50 bp cut would eat up almost one-quarter of the potential cuts. The case to do that is to prevent the slowdown from getting worse, so more cuts are not needed. But as we have seen, odds are that more cuts will be needed. Burning through a big chunk of the available cuts this early in a slowdown is a big bet that (1) the slowdown is serious and (2) this move will solve the problem. Both assumptions are far from certain.

Look for the signs

At this point, some kind of cut is baked in, and not cutting would certainly rock markets. We can count on the 25 bp cut. But a larger cut or hints in the commentary that more cuts are coming is likely to be a bad sign rather than a good one. Such hints may boost the market a bit but could spell trouble sooner rather than later.


Subscribe via Email

Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®