The Federal Reserve has started cutting interest rates at long last, and it’s a relief that financial conditions in the United States will be easing. But it’s far too early to celebrate.
The stock market has been rising anyway, with the S&P 500 closing at a new high Thursday, one day after the Fed’s action.
Even so, there’s plenty to worry about.
Start wherever you like. Personally, I begin with broad political and geopolitical concerns, not specifically financial ones, leading with the presidential election in the United States, which is still too close to call. Then, when I can stand it, I survey tensions around the globe, from the hostilities in the Middle East to Russia’s war in Ukraine to incipient conflicts involving China in the Taiwan Strait and the South China Sea.
There’s no shortage of explicit economic and financial issues percolating within U.S. borders, either. The Fed depicted its decision to reduce the benchmark federal funds rate by half a percentage point as a prophylactic measure, aimed at heading off an unemployment spiral. The economy looks fairly strong now, but unemployment has already begun to rise and in many past cycles, slowing job growth has culminated in mass layoffs. The potential for a widening economic slowdown that becomes a full-blown recession will be with us for some time.
By beginning its rate cuts with a bang, reducing the federal funds rate by twice the quarter-point minimum with which it might have started, the Fed indicated that it was reasonably optimistic that inflation would remain subdued.
Yet in a news conference after the decision, Fed Chair Jerome Powell warned, “We’re not saying mission accomplished or anything like that.” While inflation has cooled off, there’s a danger that it hasn’t been vanquished. For one thing, a wider war in the Middle East or Eastern Europe could cause another spike in the price of oil and at gasoline pumps in the United States.
Domestic Issues
That brings us back to the U.S. election. The polls are close. One possibility is a Republican sweep, giving Trump the ability to enact steep and broad tariffs, which could disrupt the economy and the markets. Another potential outcome, deemed less likely by election prediction markets, is a Democratic sweep, which could lead to higher taxes on wealthy people and corporations, upsetting the stock market. Whoever wins the presidency will need to deal with the expiration next year of the 2017 Trump tax cuts, with trillions of dollars in taxes and revenue at stake.
There are other reasons to worry about the behavior of the stock market. It may soon become difficult to ignore how high the valuations of many stocks have become. Using a wide range of traditional metrics (which I’ll return to in a moment), the market is expensive.
Public enthusiasm for artificial intelligence has been buoying share prices. But as I pointed out last week, it remains to be seen whether the billions pouring into AI will pay off in profits for big companies — or for workers whose jobs may be imperiled. AI’s ultimate profitability is critical to many stocks. Foremost among these is Nvidia, which makes the advanced chips that power AI chatbots. Nvidia is earning bundles of money but if its corporate customers fail to do so, the AI stock boom will be imperiled.
Bullish Anyway
This is a glum recitation of risks, I know, and I can come up with many more. Despite all this, however, I’m bullish on the stock market and intend to keep holding broad low-cost index funds for many more years.
But I’m doing this with eyes wide open, accepting the likelihood of intermittent setbacks in the hope of gains, which the overall stock market has granted over long periods. There are no guarantees, though. And so, while the rate cut is a step in the right direction, as an investor I’m not getting too excited.
For consumers, the initial rate cut doesn’t mean much, either. There will eventually be reduced costs for people borrowing money through auto loans, credit cards, new student loans, mortgages, business loans and more. But when mortgage rates are above 6%, half a point isn’t a game-changer. The Fed will need to follow through with more reductions for consumers to benefit significantly.
On their own, the bond and mortgage markets have already begun to give consumers some relief, easing financial conditions in important parts of the economy. Average 30-year mortgage rates for example, dropped from 7.8% in October 2023 to 6.1% Thursday, according to the Fred database of the St. Louis Federal Reserve.
The markets anticipated the Fed’s decision to reduce interest rates. That’s based on probabilities inferred from the futures markets and compiled by CME FedWatch.) What wasn’t settled before the Fed’s announcement was how low rates would go. Now the important question for both consumers and the markets is how much further the Fed will cut, and how quickly.
A consensus of Fed policymakers projected that the federal funds rate, now in the 4.75% to 5% range, would fall to about 4.4% by the end of 2024, to 3.4% by the end of 2025 and 2.9% in 2026. Those plans amount to a sea change. Recall that the Fed began raising rates from near-zero in the winter of 2022, when inflation was roaring. The annual increase in the consumer price index reached a cyclical peak of 9.1% in June of that year. Last month, it was 2.5%. The Fed is hoping it keeps falling to 2%.
But there’s skepticism in the markets about the pace of the Fed’s plans, linked to concerns that the economy may slow markedly. In a memo Wednesday, BofA Research, a unit of Bank of America, said the Fed would probably “get pushed into deeper cuts” this year and next. Considerable volatility in financial markets can be expected, the bank said.
The Stock Market
The stock market is often erratic but it has been choppier than usual since mid-July, with big weekly declines and increases following one another. Such abrupt shifts during periods when stocks were already near a peak have generally augured poorly for the market.
Fundamental measures raise questions about the market outlook. The standard price-to-earnings ratio, as well as a more sophisticated 10-year version developed by Yale economist Robert Shiller and known as the CAPE ratio, both show that prices are extremely high on a historical basis. Other metrics also show stretched valuations, like Tobin’s Q, popularized by Yale economist James Tobin, which compares the total price of the stock market with the value of the assets held by the companies within it. These measures can’t reliably forecast short-term market movements, but they suggest that over the next decade, the U.S. stock market may be weaker than usual.
Joy over falling interest rates could well fuel a protracted rally, but there are solid reasons for caution. Vanguard says the bond market now offers greater value than the stock market, though its long-term returns are lower.
All that underlines the need to diversify, by holding bonds as well as stocks, and to invest globally, keep costs low and avoid taking undue risks with money you can’t afford to lose.
Now that the Fed’s rate cutting has begun, don’t be surprised when financial markets worry about something else.
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