So The Fed Cuts Rates, Then What?

This week, the Fed is widely expected to lower interest rates for the first time since 2008. Given a decelerating global economy and mixed economic data in the U.S., along with macroeconomic risks such as U.S. – China trade talks, there are many factors affecting the Fed’s rate decision. However, the reality is that a Fed rate cut at this stage in the cycle is historically a sign of uncertainty, even if it’s cheered by markets in the short run. Is this time different?

The underlying question for investors and economists is whether monetary policy is a symptom or the cause of slower economic growth today. Even those who strongly believe that the Fed should cut rates would find it hard to argue that the economy is being strangled by high interest rates. The unemployment rate is exceptionally low, consumers in general are doing quite well, and companies have benefited from healthy demand and lower corporate taxes.

Instead, at this historic stage of the business cycle, fundamental economic factors are more likely to be the culprit. The economy is unlikely to achieve consistent 3% real GDP growth, regardless of the level of the federal funds rate. So, while the Fed can try to refill the punch bowl, the reason the party is slowing is that it’s late and the guests are tired.

Slowdowns are inevitable and entirely normal. Without fail, every business cycle follows this same basic pattern. But timing these things correctly is another issue altogether, and is all but impossible to do.

This doesn’t mean the party will end immediately. Nor does it mean that there aren’t real investment implications to a Fed rate cut. The Treasury yield curve, which has flattened over the past year and is still inverted at the front end of the curve, will be directly affected by lower short rates. Even if long-term rates stay low, short-term rates could fall, resulting in a steeper curve. Unfortunately for those investors who depend solely on interest income, this will compound the challenge of finding yield.

Risk assets such as stocks and riskier bonds could benefit from lower rates as well, at least in the short run. The stock market has already cheered a possible rate cut, with the implied probability of lower rates through next year at 100%. But once again, investors should be careful what they wish for: even if Fed stimulus helps in the short run, this could be a negative sign in the long run.

Another consideration is that many other central banks, including the ECB last week, are considering stimulative measures. This could benefit international investments as well – yet another reason investors should maintain a global investment mindset. However, it will also likely keep U.S. interest rates pinned down.

For long-term investors, staying balanced is as important as ever. While markets have already and will continue to cheer Fed rate cuts, those with a broader perspective should recognize that these cuts are born out of uncertainty. Below are three charts that address this long-term investment topic:

1. The Fed is likely to cut rates this weekMarket probabilities based on fed funds futures are expecting a 100% chance of a rate cut this Wednesday. The market also expects additional rate cuts through the next twelve months, with no possibility of rate hikes. The chart above shows the Fed’s projections from June, which suggested that even FOMC members expected lower rates in 2020. These projections will be updated in September and should reflect lower rates in 2019 as well.

The prospect of easier monetary policy by the Fed has served as a floor on the stock market – the so-called “Fed put.” The stock market has already cheered a possible rate cut and will likely continue to do so for some time. In the long run, however, investors should be cautious around what this implies for the broader economy.

2. The yield curve is still extremely flatThe yield curve continues to be flat – and is still inverted at the front end of the curve. If the Fed continues to cut rates, the yield curve could steepen somewhat as short-term interest rates decline, reversing their upward march over the past year.

At the same time, long-term rates could continue to be pinned down due to economic growth and lower international interest rates. Yields in other developed countries such as Germany and Japan continue to be extremely low and, in some cases, are still in negative territory.

3. Global diversification is more important than ever

Diversification in this environment serves two purposes. First, investors will continue to benefit from a positive market response to Fed rate cuts and the stimulus measures of other central banks around the world. Lower rates are likely to help both stocks and bonds, much as it has over the past ten years.

Second, if Fed rate cuts are the result of economic uncertainty, staying diversified will help investors navigate market volatility. As we’ve seen over the past several years, staying balanced is the best way to respond to unpredictable volatile periods.

Source: Clearnomics