The Big Picture

Briefing.com Summary:

*A December rate cut isn't a foregone conclusion, but the market still expects one.

*By one measure, financial conditions are as easy today as they were in 1998 and 2020.

*The Fed should not be cutting rates again at its December meeting.

In the Market View we published September 25, we shared our house view that two rate cuts before year-end is at least one too many. Well, the Fed cut rates at its October meeting, so that leaves just the December FOMC meeting before year-end, which means our house view now is that one more rate cut before year-end is one too many.

It sounds like the Fed may be having second thoughts about cutting rates again in December, too. Fed Chair Powell said it is not a foregone conclusion, "far from it," as there were strongly differing views at the October meeting about how to proceed in December.

The fed funds futures market looks less conflicted. Notwithstanding the acknowledgement by Fed Chair Powell, the CME FedWatch Tool shows a 65.0% probability of a 25-basis-point cut in the target range for the fed funds rate to 3.50% to 3.75%. That is down from just over 90% a week ago, but it is far from a white-flag raising after the Fed Chair's remark.

The market, from our vantage point, looks self-serving.

A Step Back in Time

Why would the Fed cut rates? Before we answer that, we are going to take you back to The Big Picture column we published in November 2021: An absurd monetary policy position is a risk we should all see coming.

The gist of that column is that it made no sense for the Fed to be at the zero bound and still embracing quantitative easing with the inflation rate at 6.2%, an economy averaging 5.0% real GDP growth, and the unemployment rate at 4.6%. It was the same policy position the Fed embraced in the throes of the Covid pandemic when the inflation rate stood at 0.2%, real GDP was negative 31.2%, and the unemployment rate was close to 13.0%.

In other words, we were imploring the Fed to raise rates and end quantitative easing. We called its ultra-accommodative position an absurd policy position and said it was a risk we should all see coming. Well, CPI inflation eventually peaked at 9.0% in June 2022, and the Fed raced to catch up with a series of rate hikes over the course of 2022, upending stocks and bonds in the process.

Nearly one-third of S&P 500 components saw a decline of at least 25% that year, as the S&P 500 in aggregate declined 19.4%. As an aside, Warren Buffett's Berkshire Hathaway (BRK.B), the same one currently sitting on over $340 billion in cash and cash equivalents, increased 3.3% in 2022.

We digress. But now we are back. The situation today is different but risks being the same.

Briefing.com Analyst Insight

CPI inflation is 3.0% year-over-year. Real GDP growth was 3.8% in the second quarter and is projected to be 3.9% for the third quarter, per the Atlanta Fed GDPNow model. The unemployment rate, at the last check before the government shutdown, was 4.3%.

For added measure, the AI investment cycle is booming, the stock market has raced to record highs, led by the mega-cap stocks but energized by the meme stocks, and junk bond spreads are about as tight as they have been in the last 30 years. Simply put, financial conditions are easy.

The Chicago Fed's National Financial Conditions Index (NFCI), which provides a weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and "shadow" banking systems, supports the latter claim.

Positive values have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions. The NFCI sits at -0.55 as of the week ending October 24, the same as it did in the week ending June 26, 1998, and the week ending November 20, 2020.

Fed Chair Powell also said at his press conference that he believes monetary policy is "modestly restrictive," shortly before adding that he doesn't see anything in the available data today that indicates the economy is seeing a significant deterioration. In his view, we are seeing a gradual cooling in the labor market and not much more than that.

The Fed, however, cut rates in September and again in October this year, citing its concerns about downside risks to the labor market. Some Fed officials are sounding a bit more circumspect about cutting rates again in December, but not all of them are.

We know which side the stock market is on, which presumably leaves us offside with our view that the Fed should not cut rates again in December. Financial conditions are easy, and the Fed would be making them more so with another rate cut at this juncture.

That would be absurd. Not as absurd as sticking at the zero bound and continuing with QE in November 2021, but in the zone of foolhardy with inflation well above target, animal spirits stirring in the stock market, quantitative tightening ending, stimulative tax policies in force, and GDP growth still above potential.

That sounds like a backdrop better suited for a rate hike than a rate cut. We know a rate hike isn't going to happen, but neither should a rate cut.

--Patrick J. O'Hare, Briefing.com

(Editor's Note: The next installment of The Big Picture will be published the week of November 10.)