On September 18, the Federal Reserve began its long-awaited shift on monetary policy and lowered the overnight Fed Funds rate by 50 basis points from a range of 5.25%-5.5% to a range of 4.75%-5%. This was the Fed’s first rate cut in four years, since the start of the Covid-19 pandemic.  In the last two years, the Fed has hiked short-term rates aggressively to fight a surge in inflation that resulted from the combined impact of unprecedented supply chain bottlenecks as the pandemic set in and the subsequent wave of fiscal spending to support the economy as the country battened down the hatches to prevent the further spread of Covid. We have now moved to a new phase for monetary policy.  Effectively, the Fed is saying the war on inflation has been won, and it is now more concerned about incipient indications of weakening in the labor market.  To increase the odds of the economy having a soft landing, in which inflation stays quiet but the economy continues to grow, the Fed opted for a larger-than-expected initial rate cut.

Lower Rates are Broadly Helpful to Consumers, the Economy, and the Markets

Lower interest rates help both to support the economy and financial markets in several ways. 

First, lower rates help companies because they reduce the cost of capital.  Companies with longer term fixed-rate debt may not see an immediate benefit, but companies with short-term floating rate debt will immediately see lower interest rate expense.  Most large companies have fixed rate debt, but many smaller companies carry floating rate debt, so these smaller companies might see the most relief over the next year as the rate cuts pile up.

Second, lower interest rates can help to support the price-to-earnings multiples at which stocks trade and the prices at which bonds trade.  All else equal, lower rates increase the value of future cash flows, thus bolstering today’s financial asset pricing.

Third, lower interest rates help consumers, who by extension help the economy.  In particular, high cost goods that are often bought on credit, such as homes, cars, solar systems, home renovations and appliances will turn over more quickly with lower rates.

Rate Cuts Mostly Baked into Stock and Bond Valuations

While the Fed surprised many economists and market participants with a 50 instead of a 25 basis point cut, we think it is important for investors to realize that this cut, as well as several more, are, in our view, pretty well baked into today’s stock and bond valuations.  Normally the beginning of an interest rate easing cycle is an opportune time to load up on stocks, but in this case, we think that stocks have already priced in much of the benefit.  Normally the Fed begins an easing cycle when the economy is in crisis and lower rates are required to avert recession. This time, the Fed is beginning to cut rates just as stocks are hitting all-time highs.  Stocks, as measured by the S&P 500, are already trading at 21 times next year’s earnings estimates, considerably higher than the 10-year average of about 16 times. Because this easing cycle was so clearly communicated by the Fed, stocks have been rising steadily since late 2023.  The same thing has happened in the bond market. Take Treasury rates, for example:  the two and ten-year Treasurys trade in the market and their prices, and therefore yields, are determined not by the Fed but by market forces.  The ten-year Treasury yields 3.73% while the two-year Treasury currently yields 3.6%, more than a percentage point below the new Fed Funds rate.  Essentially, bond traders are saying, “Hey Fed, this is where rates should be! Or lower!”

As always, we welcome your comments and feedback.  Please contact us if there is anything you would like to discuss about your investments or the markets.