The Economist: US interest rate cuts could frustrate expectations

The long-awaited moment is almost here. For two and a half years, since the Federal Reserve The U.S. has begun its fastest string of interest rate hikes since the 1980s, investors have been eager for any indication of when that trajectory would reverse. Now, it would be a big surprise if Jerome Powellpresident of the Central Bank, did not announce the first reduction of these rates after the meeting of its monetary policy committee on September 18. In fact, among investors, the debate is no longer “with” there will be a cut, but “How much”. The market estimates a probability of about 40% that policymakers will cut the rate, currently between 5,25% e 5,5%em 0.25 percentage pointsand a 60% chance that they will opt for a reduction in 0.5 points.

Based on investors’ reactions to Powell’s statements over the past few years, one might think this would be great news for them. After all, the U.S. stock market has spent much of that time plummeting whenever it looked like interest rates would stay high for longer, and rising at any suggestion that borrowing costs might fall soon. But it’s no wonder that the saying goes: “buy on rumor, sell on fact” is so enduring in financial markets. While the prospect of interest rate cuts quickens investors’ pace, the actualization of those cuts often ends up being disappointing.

Consider how stock prices have reacted to previous easing cycles. Although the three episodes in the 1990s under Alan Greenspan at the Fed, have boosted the stock market, the record of this century has been more dingy. Rate cuts in the early 2000s came during the dot-com bust; those in 2007 coincided with the global financial crisis. The softer turnaround that began in 2019 initially boosted stock prices, but the effect has been overshadowed by the Covid-19 pandemic.

Like so many things in finance, rate cuts have a small effect (in this case, positive) on stock prices that can easily be overshadowed by other factors. The boost comes from lower borrowing costs, which allows companies to keep more of their profits and encourages consumers to spend more on their products. If bond yields also fall, the potential returns on stocks become even more attractive by comparison, providing another boost.

So what factors could be muddying the waters this time around? One is a recurring one: Money never gets cheaper on its own, but because central bankers fear economic weakness and want to avoid it. Right now, that seems to be less of a concern than it normally would be. While the U.S. labor market has cooled, which caused a brief scare among shareholders over the summer, the economy appears to be slowing, but no entering a recession. Corporate profits should therefore be safer than usual when the Fed starts cutting rates – and with it, so should stock prices.

More worrying are the famous “long and variable delays”as appointed by Milton Friedmanbetween changes in monetary policy and their impact on businesses and consumers. Counterintuitively, even as the Fed prepares to ease, many borrowers will face higher interest bills. Any company that issued fixed-rate debt when money was cheap, and there are many, will eventually need to refinance. Since the Fed is not expected to bring interest rates back to zero any time soon, these companies’ debt-servicing costs will continue to rise for some time. Homeowners with fixed-rate mortgages who need to refinance (after moving, for example) will be in a similar situation. So rate cuts may stimulate the economy, and thus the stock market, less than they would have in the past.

The biggest clue that the Fed’s generosity may disappoint investors, however, is how much the market has already expected it. At the moment, traders’ central expectation is for cumulative cuts of 1.25 percentage points by the end of the year, followed by more 1,25 next year. Such rapid movements have occurred in the past only in the midst of recessions or crises. In other words, there is plenty of room for Powell surprise with a more conservative stance, even as it cuts rates, which could push up bond yields and make stocks less attractive. Interest-rate cuts should be good for the stock market, but not if investors have already anticipated the full benefits.

Via The Economist*