Published August 23, 2024
The market is eagerly awaiting the commencement of Federal Reserve interest rate cuts next month. The sharp, nonstop rebound from the August selloff provides ample evidence of investor enthusiasm for the upcoming cuts. Market interest rates have fallen back to where they were 18 months ago. The chart below shows how the yield curve has changed over the past year. The left side of the curve displays very short-term rates (1 month to 1 year) which are driven by the Fed. They have been anchored to the Fed’s 5.25% short-term target rate while the longer-term rates have fallen notably.
That short-term rates are higher than longer-term rates means the curve is “inverted”. That’s not the norm. Typically, the yield curve pushes up and to the right with investors requiring more compensation (“yield”) for the uncertainty inherent in lending money for longer periods of time. The ultra-short term “money market” rate is usually the lowest, quite a bit lower than the rates further out in time.
As the Fed embarks on cutting rates, this curve is expected to return to normal with short-term rates falling sharply while longer-term rates hold steady. The normalization of the yield curve is usually good for banks, in particular, as they lend out at higher rates than they have to pay on deposits.
But is the presumed normalization of interest rates always a good thing? The chart below from Sam McCallum shows that interest rates becoming “un-inverted” has often coincided with a decline in the stock market. This has been true over the past 20 years.
Picking a bit on the chart, we note that in every case the stock market fell BEFORE the rates normalized (became un-inverted).
Let’s back up a bit. Interest rates become inverted in one of two ways – either short-term rates are seriously hiked up in an effort to quash “out of control” economic growth or high inflation; or, longer-term rates fall because the market thinks the economic outlook is deteriorating.
Rates become un-inverted when the Federal Reserve unwinds their short-term rate hikes. They usually do this because of some market or economic duress. That was the case in each instance of the above. The Federal Reserve dropped short-term interest rates because of an economic calamity. Cost inflation has not been a major consideration in any of these cases.
This time might be different. Zero interest rates clearly caused some amount of market overheating in the form of asset price inflation – remember $100k for a digital picture of an ape? Or the melt-up of the startup market in 2021 where new ventures with nothing more than a clever name raised tens of millions of dollars? Or house prices vaulting 20-30% seemingly overnight with buyers lined up around the corner, and bidding wars the norm?
The inflation was not only in asset prices. Post-pandemic supply chain dislocations and bidding wars for labor pushed costs higher resulting in widespread cost inflation for the first time in decades. Inflation is clearly normalizing at the 2-3% “target” level while asset prices have also flattened out. The Fed will respond to this return to normal by bringing interest rates back down to normal levels.
The Fed hopes it is not behind the curve, as they so often have been. Markets hope so too. Investors generally believe that economic growth and corporate earnings are solid, and that the lower interest rates are simply reflecting lower inflation (and not weaker economic growth). If that proves to be true, the nirvana of a “soft landing” will be in force and the chart above will ultimately show a different result this time.
Market Update
After battling back from the abyss last week, investors looked to fresh inflation updates this week in hopes of keeping the rebound going. Would inflation continue to trend downward paving the way for September Fed interest rate cuts? Ahead of those reports, stocks traded flat Monday. The first of the inflation reports hit the wires Tuesday with Producer Prices only up +0.1% from the prior month (thus a below-target +1.2% annual inflation rate). Stocks rallied on the news while bond yields fell. That sentiment flowed into Wednesday with stocks adding another +0.4%. Consumer prices showed inflation running under +3% for the first time in three years – all but insuring the Fed will cut rates in September. Investors quickly began debating whether the central bank might even opt for a 0.5% cut. The cheer rolled on Thursday with nothing but good news: a positive surprise in retail sales growth confirmed by strong sales growth at retail behemoth Walmart. Walmart surged +6% after their earnings report as the company saw no deterioration at all in customer demand. This assuaged investor fears after other retailers reported concerns about demand last week. Stocks zipped higher by +1.6%. Stocks held their gains in Friday’s session adding +0.2% as investors have quickly returned to the “soft landing” economic narrative – a nirvana scenario for stocks where growth is strong while interest rates ramp down.
Stocks posted their strongest week of the year recovering all of the damage from the first week of the month. The S&P 500 vaulted +4.00% for the week. The Nasdaq 100 (QQQ) gained +5.47%. Small-cap stocks lagged posting a +2.97% increase.
Warm wishes and until next week.