INSIGHTS

On September 30, 2024

AAM Viewpoints — “Why” the Fed Cut Rates is Important…Now What?

After many months of guidance, market prognostications and seemingly constant media coverage, the Federal Reserve Open Market Committee (FOMC) lowered the Federal Funds Rate by 50bps (basis points) on September 18. The effect is a pivot from what has been considered a “restrictive” rate environment of higher rates to an easier one in which rates are lower — at least lower than they were. There is more we can debate on whether the current level of rates is actually restrictive, or just “average,” historically, and really shouldn’t be considered “high.” Generally, when the Federal Reserve (Fed) begins cutting rates, they are doing so because they consider some component about the current economic environment out of balance from what they want to achieve. The major reasons could be that in their view inflation is no longer too high, unemployment is rising to an unacceptable level or macroeconomic conditions are dire enough now, or will be in the near future, to warrant a rate cut to stave off a recession. 

With inflation measures such as CPI (Consumer Price Index; excluding food and energy) falling yet still over 3%, and their preferred data point of PCE (Personal Consumption Expenditures) at 2.5%, both versus the Fed’s stated target of 2%, one could say inflation is going in the right direction, but not quite there yet. The Fed’s other stated mandate of full employment remains rather robust currently with the last initial jobless claims data and continuing claims data remaining near recent averages and non-farm payrolls actually coming in higher than the prior collection period and the survey of economists on the data point. The natural inclination would be to ask why then the Fed might cut 50bps instead of 25bps (a typical “single” Fed rate cut). It could be that they felt behind and should have cut sooner. It is also possible they could see something none of the rest of the general population is privy to. For example, in August the Bureau of Labor Statistics — which releases employment data — made a major revision of 818,000 fewer jobs than originally reported for the six months ending in March, which itself is concerning to be that far off, but if a trend instead of an outlier even more so. That said, at this point it seems more likely that the FOMC is just convinced they are going to be able to stick the soft-landing and continue economic growth without reigniting inflation — despite constant government spending.

The Fed has had seven cutting cycles since 1990 and typically a rate cut is followed by a recession within 18 months or so. While it is possible to engineer a soft landing of course, history may not be on their side. Some Fed governors have recently made statements that they may want to cut “several more times in this cycle.” Our hope is that being this close to a national election in the U.S., the Fed hasn’t or doesn’t stray from their stated position of political neutrality. Cycles take time to play out, so we’ll have to wait and see if they can accomplish this goal, or if we move closer to a recessionary environment.

One indicator that has been used to foreshadow recessions is the difference between the yields on the 10-year Treasury and the 2-year Treasury (10s/2s). At the end of August, the longest period of 10s/2s curve inversion ended, which lasted over two years. While historical data suggests that recessions have followed about seven months after curve dis-inversion/flattening, it is possible this time is different…?

Longer-term rates have fallen this year, with inflation slowing and market participants betting rate cuts could portend a more dire environment, and it has also provided the Fed cover to cut short-term rates. As the Fed cuts, it stands to reason that the curve would flatten or become positively sloping, as they control only the extreme front-end of the rate curve. Longer-maturity Treasuries reflect the market’s view on longer-term economic growth and inflation (not considering any direct government involvement in markets). If the same market dynamic persists, or a recession does in fact set in, Treasury prices could have more upside from here making longer maturities more attractive to investors — especially given a positively sloping yield curve.

So, where does that leave credit investors? So far, broad-based spread tightening, coupled with a rally in underlying risk-free rates, have resulted in good excess returns for those investors of both investment grade and high-yield corporate bonds. In this cycle thus far, credit spreads have been incredibly resilient with inflation cooling (lower input costs and higher margins) and the Fed cutting rates. The “why” of the rate cuts will be important looking forward. If a soft landing is achieved and a recession and a major spike in unemployment is averted, credit spreads will likely stay in the currently historically tight range. On the other hand, worsening economic conditions cause stress on earnings as consumers delay or pull back on planned spending resulting in lower earnings and higher credit risk premium (higher credit spreads).

With the curve now (mostly) positively sloped and corporations still reporting generally good earnings, we believe it may be a good time to lock-in additional yield available in modestly longer maturities along the credit spectrum. However, credit selection will be important if conditions deteriorate enough to force credit spreads wider. Lower-rated companies with higher amounts of leverage deployed and higher exposure to weakening consumers won’t be well-positioned and could see underperformance in that environment. Sectors such as media, telecommunications, consumer goods, healthcare and leisure generally employ more leverage than their benchmark index, especially in those rated lower investment grade and high yield. Credit selection within these sectors, as well as overall, can be used to potentially protect against those types of adverse recessionary factor (i.e. defaults). There are certainly opportunities, but also pitfalls, if things don’t go exactly as planned. 

CRN: 2024-0903-11952 R