FORECASTS & TRENDS E-LETTER
By Henry Rohlfs
July 2, 2024

IN THIS ISSUE:

1.  Rate Cut Back on the Table

2.  “The Economy, Stupid!”

3.  How a Rate Cut is Good For Investors

4.  A Final Thought

The latest data on the fight against inflation arrived last Friday in the form of the Personal Consumption Expenditures index, the Federal Reserve’s preferred measure of inflation. We’ll take a quick look at those numbers, then follow with a guess of when the Fed will begin to cut interest rates.

Then on to economic concerns as they affect the U.S. presidential election. Finally, we’ll take a closer look at what could happen to the markets once rate cuts begin.

Let’s get started.

Rate Cut Back on the Table

The core Personal Consumption Expenditures (PCE) index rose 0.1% in May from April, matching the expectation of most observers. Inflation has slowed since April's 0.3% increase. The inflation gauge now sits at 2.6% year over year for both the PCE deflator and core PCE, which excludes food and energy prices.

With numbers pointing toward cooler inflation, the possibility of a rate cut before year's end may be back on the table. But Federal Reserve governors have been adamant that a rate cut this year is just a possibility and not guaranteed.

Fed Governor Michelle Bowman said in a speech last week that she is still not ready to support a central bank rate cut.

In her speech, Bowman said overall activity is strong this year but had moderated and progress on inflation reduction has stalled. She noted an easing in financial conditions was creating challenges for the future direction of prices.

“Should the incoming data indicate that inflation is moving sustainably toward our 2% goal, it will eventually become appropriate to gradually lower the federal funds rate to prevent monetary policy from becoming overly restrictive,” Bowman said, adding “we are still not yet at the point where it is appropriate to lower the policy rate, and I continue to see a number of upside risks to inflation.”

In contrast, Atlanta Federal Reserve Bank President and FOMC member Raphael Bostic was more optimistic. He said last Thursday that he is sticking with his forecast of a 0.25% interest rate cut this year, sometime in the October-December quarter.

“Taking all the circumstances into account, I continue to believe conditions will likely call for a cut in the federal funds rate in the fourth quarter of the year,” Bostic said in a new essay published on his regional bank’s website. At the same time, he said he wasn’t “locked in” to any particular policy path.

My colleague Spencer Wright and I have been trying to guess when the elusive initial rate cut would occur. My bet was September while his was after the election in November. It looks like Spencer might win that one.

“The Economy, Stupid!”

If you missed Spencer’s article Stock Market Returns During Presidential Election Years, take a moment to read it. His summary is insightful and the statistics very interesting. Even back in January, he said, “The economy is often a key issue in campaigns if not THE issue.”

Democratic Party advisor James Carville famously said in a televised quip, “The economy, stupid!” The economy was in recession and this Clinton campaign de facto slogan helped to unseat George H.W. Bush in the 1992 presidential election. He even hung the saying on a sign in the Clinton campaign headquarters to keep everyone on message.

This year’s campaign is no different. Although we are not in a recession – at least not yet – inflation is the surrogate for economic woes. Gallup reports that economic issues and the economy in general top the list of concerns Americans have – hands down.

Speaking of inflation, the topic was a big one at last Thursday’s presidential debate along with tariffs, tax legislation and the national debt. Moderators Jake Tapper and Dana Bash mentioned the economy as the "issue that voters consistently say is their top concern."

How a Rate Cut is Good For Investors

But when the Fed decides to cut interest rates, we can expect to see stock prices surge. Here’s how this would work.

For example, early in 2024 futures traders were pricing in a quarter-point rate cut for March. The market’s anticipation had a positive effect on stock prices since it assumes that a company’s earnings per share and profits will rise as borrowing becomes cheaper.

In effect, lower interest rates lead to higher price-to-earnings metrics and vice versa. But this is not the only way they help the market.

Many trading departments on Wall Street, like hedge funds, prop desks at mainline brokerage firms, mutual funds, etc., use extensive amounts of leverage to purchase their positions in the market. So lower short-term interest rates improve the costs of this borrowing activity. This, in effect, can help boost profits and can potentially increase share prices.

Besides stocks, these positions can also include other leveraged securities markets. Think Treasury notes or secondary loan markets such as collateralized loan obligations (CLOs). For example, the secondary market in CLOs, which are essentially bank loans of major corporations that trade on the market, become more liquid and profitable with lower rates.

The bottom line is that interest rate movements can dramatically affect the borrowing costs of large Wall Street firms. With lower borrowing costs, these companies can improve their profits.

As a result, trading institutions tend to push up prices when interest rates and Treasury yields fall. The opposite also occurs when rates rise. The market anticipates lower inflation and lower interest rates as a result. This will potentially lead to higher stock prices, higher bond and note prices (and lower yields).

A Final Thought

Of course to be fair, not everyone believes the economy is on sure footing. Paul Dietrich, B. Riley Wealth Management’s chief investment strategist and frequent Fox Business contributor, thinks the economy is still headed to a recession this year. He sees the S&P 500 dropping a whopping 48%.

He notes in his latest commentary that the market’s recent gains have been driven by investors’ excitement about a handful of stocks like Microsoft and Nvidia and hopes that the Fed will cut interest rates this year. He points to hugely overvalued stocks that are close to suffering a correction.

Who is right? Only time will tell, of course. In the meantime, let’s keep an eye on the Fed, inflation and the candidates running for president. We are in historic times – don’t miss it.

I hope you have a great Independence Day! Be sure to take a moment to be thankful for the blessings and opportunities we have in our country.

All the best,

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