Another rate cut—Is the U.S. economy weakening?
In yesterday’s Federal Open Market Committee (FOMC) meeting, the Federal Reserve (the “Fed”) lowered interest rates for a third time. The Fed made it very clear that this 25-basis point cut – to a target range of 1.50% – 1.75% – was the last for the foreseeable future unless the U.S. economy takes a turn for the worse — which we believe is possible. As a result, we are focusing on capital preservation more than chasing returns and building flexibility for short-term opportunities.
What is next for interest rates?
The Fed is on hold for the foreseeable future, and the bar for further rate cuts is higher than market participants may be hoping for. Fed Chair Jay Powell said that he sees the current monetary policy stance as “appropriate” for the time being, and that they don’t need to take out more “insurance.” That means we won’t see more cuts unless the economic outlook deteriorates: data turns further downward or downside risks worsen.
Our base case suggests the economy will gradually slow in the next 12-18 months, increasing the likelihood of more rate cuts. In the short term, however, we are monitoring investor expectations, which might outpace the reality of interest rate cuts and create tactical opportunities.
Those balance sheet changes sound a lot like quantitative easing (QE). Are you paying attention?
In addition to its interest rate cut, the Fed crystalized its commitment to increase the size of its balance sheet. For the next several months, the Fed will purchase T-bills to increase its stash of reserves.
These purchases should not be confused with quantitative easing. QE implies an asset purchase program meant to influence long-term interest rates to help boost investment. In this case, the Fed is buying short-term bills rather than long-term bonds. Bill purchases should have little, if any, effect on longer-term interest rates and assets. Less stress in short-term lending markets is a good thing, but we don’t expect any meaningful effect on household or business spending decisions.
We could see further action from the Fed to support short-term lending markets. For example, because the Fed will buy so many T-bills in the next few months, it’s possible that they could also have to purchase very short-maturity Treasury coupons to maintain its promised purchases ($60 billion per month). It’s also likely that the Fed will create a standing repo facility to reduce the risk of higher overnight interest rates. However, the Fed is likely to hold off on further action until next year, when its balance sheet expansion program is up and running. While we’d expect these additional measures to reduce short-term liquidity risks, they also should not be perceived as QE.
What does this mean for investments?
The economy is slowing, profit margins have peaked, the Fed is now back on “pause,” and equity markets are making new all-time highs. While we do not see disaster as imminent, we are staying on the “cautious” side of this late-cycle expansion.
If economic data firms up, or if geopolitical risks continue to fade, then we could see some potential for cyclical assets – investments that do well when the economy is accelerating – to outperform in the short term. As a result, where we are reducing high-risk exposure, we are increasing some flexibility to take advantage of short-term improvements.
On balance, though, and in this phase of the cycle, we favor capital preservation over chasing returns. Unless we see a clear, sustained turnaround in economic data, we think it’s too early to pile back into risk assets.
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