The Fed cuts - now what?

Economic vista: The Fed cuts – now what?

Jeff Probst, CFA, Portfolio Manager

Finally! Investors had been eagerly expecting—some might say hoping—for the Federal Reserve (Fed) to ease monetary conditions for the better part of this year. Yet it wasn’t until this summer that the Fed was satisfied with both declining measures of inflation and the easing of tight labor markets. So in September, the Federal Open Market Committee (FOMC) took the bold move of initiating the rate cutting cycle with a 50-basis point (bps) cut to the fed funds rate. This marks the start of a new era and marks the first rate cut since the pandemic. But now investors want to know how low will the Fed go, and how fast?

There’s no doubt that this can be viewed as an aggressive first move, especially without an exogenous crisis lurking in the background. Market pundits were largely split between a 25- or 50-bps move. But the very restrictive prior monetary policy (the “higher for longer” era) in conjunction with moderating economic data provided enough justification for the FOMC to take the bold move and cut by 50-bps. Nevertheless, the Fed made it clear that this move was not from a place panic or concern, but more of a confirmation that previous policy moves have worked and now is an appropriate time to begin a new cycle.

Learn By Looking Back

When the FOMC embarked on raising the fed funds rate in early 2022, their goal was to slow an overstimulated economy and bring Core Personal Consumption Expenditure (Core PCE) inflation towards the 2% long term goal. In doing so, the Fed also expected unemployment to increase from a very low starting point. Significant progress has been made toward both initial goals, yet the amount of restriction the Fed has placed on the economy has only risen as inflation moderated. A common and easy way to evaluate the level of accommodation or restrictiveness of monetary policy is to compare the difference between the fed funds rate and Core PCE. Typically, if Core PCE is greater than the fed funds rate it would indicate monetary policy is accommodative. If the fed funds rate is greater than Core PCE, we would consider policy as restrictive.

Over the past ten years, the Fed has orchestrated two very different hiking/cutting cycles, but its actions and communication have largely been in alignment. They tend to proceed with caution while trying to get back to a neutral monetary policy stance. Looking back to the hiking cycle when the economy was recovering from the Great Financial Crisis (GFC), the fed funds rate was pegged at nearly zero for many years to help stimulate the economy. The FOMC ultimately wanted to increase the fed funds rate so it would have that tool available in its monetary toolbox. However, persistently low inflation made that task difficult. Starting in late 2015, the Fed started hiking the fed funds rate in gradual 25-bps increments, usually every three months with a few longer breaks between hikes. The Fed was in a very accommodative position as inflation was well above the fed funds rate. But since Core PCE was struggling to approach the 2% target, the FOMC remained very cautious on its approach to raising the fed funds rate. The FOMC did not want to derail the fragile recovery but wanted to regain the ability to ease if another issue surfaced.

The Fed was comfortable with Core PCE near 2%, but once it started to trend lower and the level of monetary policy restrictiveness increased, the FOMC started to adjust monetary policy by cautiously cutting the fed funds rate. The Fed was fine-tuning this policy until COVID-19 abruptly threw all forecasts out the window.

Aggressive or Cautious?

How exactly should investors view the most recent move? While the 50-bps cut that the FOMC announced in September may appear like an aggressive first move, it’s important to remember just how restrictive monetary policy had become since its last adjustment to the fed funds rate (rate hike in July 2023). At that point, the difference between the fed funds rate and Core PCE was around 1.5%, which then increased to over 2.6% during the summer of 2024 as Core PCE moderated. Thus, even after the recent 50-bps cut, the difference between Core PCE and the fed funds rate is still over 2.1%, which is still much more restrictive than after the last hike. Using this basic gauge of monetary policy restriction, we think it’s clear that the FOMC is not overreacting to the level of restriction, but instead following through with its previously communicated strategy to lower the fed funds rate in a data-dependent and cautious manner.

In the rate hiking cycle that emerged from the GFC, the FOMC took approximately three years to raise the fed funds rate 225 bps, a very slow pace by historical standards. Even in the most recent cycle, the FOMC was slow to raise the fed funds rate because it was skeptical about inflation data and didn’t want to damage the economic recovery. Fast forward to today and we see some similarities. Despite the aggressive first 50-bps cut in September; one can argue that the current easing cycle is actually following a conservative trajectory. Several times in the past year the market became overly optimistic that the FOMC would begin cutting the fed funds rate, yet all the while the Fed was preaching patience. And less than two weeks after the most recent rate cut, Chair Powell said, “This is not a committee that feels like it’s in a hurry to cut rates quickly.” And he added, “…policy will move over time toward a more neutral stance.” The message seems clear. Don’t get too ambitious with forecasts of future cuts.

Given the significant level of monetary restriction still in the market, both the market and the Fed expect additional fed funds rate reductions in 2024 and 2025. Of course, determining the appropriate level of monetary policy restriction or accommodation can be a bit of an ambiguous task. The FOMC must consider an array of both lagging and forward-looking data indicators when it crafts its monetary policy decisions. To complicate matters, some of the economic indicators have inherit deficiencies that can often make the decision-making process more difficult. Plus, monetary policy actions have a delayed impact on the economy, which makes it difficult to measure effectiveness.

While the media and public have been fixated on the movement of the fed funds rate (a rate that has little direct bearing to the financing costs of consumers, corporations or government), investors must digest economic information and other factors to get a better understanding of the yield curve. To some this may seem counterintuitive, almost the entire yield curve has moved higher since the FOMC voted to cut the fed funds rate by 50 bps. But there are nuances at play, and even though the FOMC may be cutting the fed funds rate to ease the level of restriction, there are other forces influencing the yield curve.

Looking Ahead

Now that the first cut is in the rear-view mirror, where do we go from here? The simple and boring answer is that it is data dependent. At the September FOMC meeting the Fed forecasted additional future rate cuts—50 bps more in 2024, 100 bps in 2025, and 50 bps in 2026—for a total of an additional 200 bps of cuts in this cycle. The market, on the other hand, has the same total rate cuts priced in, but it largely expects the moves to happen the third quarter of 2025 (as of 9/30/2024). This is more aggressive than the Fed is suggesting, though things can and do change. Disagreement among the Fed and market forecasts is nothing new. But it's important to remember that the Fed tends to be cautious, while the market is often overly optimistic. A new monetary cycle may be here, but in our opinion, we think the FOMC will continue to lower the fed funds rate cautiously.

Trading vista: The first cut is the deepest

Jason Graveley,  Senior Manager, Fixed Income Trading

While the size of the FOMC’s 50 bps rate cut in September was hotly debated ahead of the meeting (would it be 25 or 50 bps?), the more aggressive first move provides some insight into the Fed’s thinking. The deeper cut suggests that the Fed is confident that the current trajectory of inflation remains acceptable and that they prefer to preserve labor market strength and support economic growth. In other words, let’s hope for a soft landing.

A decisive October payrolls report reinforced the strength of the labor market, where the data easily cleared even the most optimistic estimates. In response, we saw Treasury yields move higher, with the 1-year Treasury bill yield moving up 22 bps in the week after the data release. This suggests that the market now envisions a more gradual path of rate cuts going forward.

So now that cuts have started and the market has aligned to some path of policy expectations, what should investors be focused on? Balances in money market funds will likely be top of mind, as changes to policy rates show there immediately. Government and Treasury money market funds have already started to reflect the move lower in yields, but there is some difference on how quickly shifts in policy rates make their way through each type of fund complex. Government money market funds are more likely to reflect a rate cut sooner, since they generally have large holdings in overnight and short-term repurchase agreements (repo). Repo rates will generally reset faster in both hiking or cutting cycles, as the market reprices instantly, and rates tend to show up as soon as the next day. In contrast, Treasury-only portfolios, those that don’t invest in repo obligations, tend to respond more slowly through the cycle. In this case, with the 50-bps cut in rates, Government and Treasury funds have fallen by approximately 30 and 20 bps, respectively, through the first week in October.

Still, if investors want that cash-like liquidity, what are the alternative investment opportunities? Money market fund yields remain attractive in their space and still boast more than $6.6 trillion in balances, having logged more than $450 billion in inflows this year. That’s quite the haul for this asset class in the face of a new rate-cutting cycle, which everyone knew was coming. We think that money market funds will remain popular over the short-term, largely because these funds tend to support nearer-term liquidity needs and are best compared to alternative liquidity products (such as a savings account or short T-bills). The 3-month Treasury bill is yielding 4.65%, as of the first week of October, and it tends to move lower along the bill curve, which reflects the likelihood of more rate cuts before the end of the year. Meanwhile, Treasury-only money market funds are yielding 4.77% as of this writing.

So, for those that have true daily liquidity needs, there will be little impetus for change, and portfolios will probably diverge along the line of cash flexibility. For those that have a longer runway, extension opportunities have already come into focus with 2-year yields hovering around 4%. While we do expect some portfolios to extend to lock in higher rates over a longer period, we don’t expect the first rate cut to cause tectonic movements among many short-term cash investors.