Powell enters the endgame

Market Recap

• Equity markets rallied this week alongside a 50 bp rate cut by the Federal Reserve.

• The S&P 500 added 1.4%, led by banks, energy and telecom services, while the tech-heavy Nasdaq gained 1.5%.

• Indeed, it was growth that benefited most this week alongside the hefty chop, not rate-sensitives which lagged along with defensives.

Interest rates

Last week, the U.S. Federal Reserve made a big move, lowering interest rates by 50 basis points and kick-starting the rate-cutting cycle in the world’s largest economy. I was a little surprised that they opted for a bigger cut, though not everyone on our team was. A 25-bps cut would arguably have been the more cautious, politically-savvy move, as it would have sidestepped questions about the economy’s health or whether the Fed had started the process too late. In our view, the Fed probably did feel that they were a bit behind the eight-ball, though that point wasn’t obvious to markets. Regardless, the majority of Fed members were on the same page and seemed very confident going with 50-bps this time around. Fed Chairman Jerome Powell made it clear in his comments that this should not be interpreted as a pattern—each rate decision will be examined on its own merits, so a 50-bps cut now doesn’t necessarily mean a 50-bps cut at the Fed’s next meeting in November. Rather, Powell framed this move as a way to get the ball rolling, which is likely why markets had a relatively muted response to the cut on the day of the announcement. They also highlighted that economic activity has continued to expand at a solid pace, but job gains have slowed. Overall, we think the Fed demonstrated a good balance between messaging and action. Markets hit all-time highs the day after the announcement, so market participants were definitely happy with the 50 bps and commentary thereafter.

Bottom Line: While the 50-bps cut may have been a mild surprise, Powell’s comments did a good job explaining the decision and setting the tone for future easing.

Bonds

Following last Wednesday’s rate cut, the yield on 10-year U.S. Treasuries rose rather than fell—a counterintuitive movement given that bond yields tend to decline when interest rates are lowered. Our read is that markets were expecting a rate cut and a 50-bps decrease was seen as a strong possibility, so the impact had already been priced in. Looking ahead, if rate easing continues as expected, yields are likely to come down, perhaps normalizing the yield curve after a prolonged period of inversion. The Fed’s 50-bps move is a definitive sign that central banks around the world have moved into cutting mode. This should be good news for bond markets, and it gives investors license to be a bit more aggressive in their fixed income allocations; in our view, cash should underperform bonds going forward. Even if the economy does slow down and equities take a hit, that provides an opportunity for bonds to prove their worth as a stabilizer and diversifier, rather than being highly correlated with equities as we’ve seen over the past couple of years.

Bottom Line: Further rate cuts by the Fed and other central banks should be beneficial to bond markets.

Consumers

As the Fed continually reminds markets, they are “data-dependent,” meaning that they base their decisions on the economic statistics and forecasts at their disposal. In that sense, last week’s 50-bps rate cut can be seen as a comment on the state of the consumer, with the data indicating that they are slowly softening again. The number of jobs available is diminishing; consumers are continuing to adjust their spending patterns from discretionary items to staples; and consumer sentiment has been trending down over the last few months (though it did go up slightly last month). What the Fed is hoping to avoid with its big rate cut is consumers worrying about the job market and deciding to slash their spending. In the Fed’s view, a reduction in spending is acceptable if that’s what’s needed to keep inflation in check. But if consumers stop spending, that would imperil the economy’s ‘soft landing.’ It’s a similar thought process for the Bank of Canada (BoC): they know that people will be coming up against a steep mortgage wall over the next couple of years and are cutting rates now to minimize that burden. It’s also worth remembering that while rates are now declining, they’re still higher than they were two or three years ago, and their impacts will continue to filter through the economy for some time.

Bottom Line: Data shows that the consumer is gradually weakening, and with its 50-bps cut, the Fed is trying to maintain a ‘soft landing.’

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Riding the tailwinds of September storms.