Uncertainty Looms After Fed Rate Cut
Investors appear to be bracing for a bumpy few months after the Federal Reserve resumed cutting interest rates and opened the door to further easing, while simultaneously issuing warnings about sticky inflation.
Some investors now seem less certain that the rapid shift to lower borrowing costs will materialize, which could dampen optimism that stocks and bonds will get a strong boost from looser policy. Adding to the uncertainty is a significant divergence of views within the Fed about the future path of interest rates.
"We've held a fairly cautious, but not entirely defensive, view for some time, and now the Fed's message reinforces that view," said Larry Hatheway, global investment strategist at Franklin Templeton Investment Institute.
Hatheway added that many in the market may be slightly disappointed by the Fed's lack of clarity and direction, with the central bank not explicitly endorsing market expectations for a clear string of rate cuts, but instead emphasizing a meeting-by-meeting, data-dependent approach.
Impact of the Rate Cut and Mixed Messaging
On Thursday, the Fed lowered its policy rate by 25 basis points to a range of 4%-4.25%, its first cut since last December, and signaled it would embark on a gradual easing cycle in response to growing labor market concerns. At the same time, Fed Chair Jerome Powell highlighted a "challenging situation" facing policymakers, noting that inflation risks are tilted to the upside while employment risks are tilted to the downside.
Those comments curbed market optimism, even though the market had been keenly hoping for a dovish pivot from the Fed after recent data showed the unemployment rate climbing to 4.3% in August and job gains coming in well below expectations.
A sharp downward revision to annual jobs data through March earlier this month also further supported the view that the labor market is losing momentum, providing justification for the Fed to cut rates multiple times in the future.
A Closer Look at the Fed's Projections
Compared with the dot plot released at the June meeting, the latest dot plot reflects expectations for more easing this year, with forecasts for another 50 basis points of rate cuts by the end of the year.
Meanwhile, the Fed’s forecasts still see inflation at 3% at the end of this year, well above its 2% target, while its forecasts for economic growth were revised slightly higher to 1.6%, up from 1.4% in June.
"The market may welcome this easing bias, but the message that it conveys remains nuanced and far from a full pivot," said Dan Siluk, global head of short duration and liquidity and portfolio manager at Janus Henderson Investors.
The Nasdaq and S&P 500, which had been near record highs ahead of the meeting, wobbled to close lower.
U.S. Treasury yields rose, with the 2-year Treasury yield up 4 basis points on the day to 3.55%, while the benchmark 10-year Treasury yield rose about 7 basis points to 4.09%. In recent weeks, the yield curve has been flattening on rate cut expectations, with the gap between long- and short-term yields narrowing.
"The Fed is in a difficult spot," said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. "They’re forecasting stagflation, meaning higher inflation and a weaker labor market. That’s not a good environment for financial assets."
Stagflation Risks Loom
The U.S. consumer price index (CPI) for August posted its biggest increase in seven months as housing and food costs rose, sending the annual inflation rate to its highest level since January.
Coupled with weakening labor market conditions, the higher inflation has sparked fears of stagflation. This is a worrisome combination of slow growth and high inflation that plagued the U.S. in the 1970s and could complicate the Fed’s ability to support the job market through aggressive rate cuts.
"It’s far from 1970s stagflation, but at the margin, it supports taking a more conservative outlook on stock and bond returns," said Michael Rosen, chief investment officer at Angeles Investments.
Political Reactions and Divisions Within the Fed
In the wake of the Fed’s shift toward easing, the move is under scrutiny, after the Trump administration had placed relentless pressure on the Fed to cut rates.
Trump nominee and economic advisor Miran sworn in as a member of the Fed’s board of governors on Tuesday, cast the sole dissenting vote against the Fed’s 25 basis point rate cut decision, instead advocating for a much larger 50 basis point cut.
The market also had to grapple with the wide range of forecasts shown by the Fed’s dot plot, with one participant forecasting a 4.4% interest rate at the end of the year, above the new 4.00%-4.25% range. On the other end, one policymaker penciled in a year-end policy rate of 2.9%.
"I think the market is having a difficult time digesting all the information that they're getting. Certainly, it's not giving anybody a very clear view about how Fed policymakers are going to be making decisions," said Josh Hirt, senior U.S. economist at Vanguard.
Hirt added, "There's so much disagreement amongst committee members that uncertainty has been heightened, and one potential consequence that stems from that is greater volatility."
VN
