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The Federal Reserve has begun another rate cutting cycle, with an apparently uninspiring (to the markets) 25 basis point cut. They were placed into a tough spot by political interests, and pressured into what they’re calling “preventative” action to keep the economy growing and hopefully avoid recession. We are highly skeptical that this rate cut will have any real impact on economic growth, which although it has been showing signs of slowing down, is still growing. But this may not be the reason the Fed is taking their action.
This cut (and potentially a subsequent cutting cycle) could have the effect of increasing inflation, and this outcome may be what is desired at the Fed. Globally, conditions of stagnant inflation and even deflation have been difficult, if not impossible, to reverse once they have taken hold. Japan is a clear example of this, but even here in the United States, normal levels of inflation have been notably absent (with the exception of brief periods in 2011, 2017, and 2018) for the past decade.
In terms of stocks, the S&P 500 closed July at 2980, off its all-time high by ~1.6%, in response to being unsatisfied with the 25bps rate cut. We continue to have a defensive view, and are forecasting increasing volatility through the year end. Notably, stocks appear to have entered a period of abnormal behavior, in that they are broadly responding positively to negative news and negatively to positive news. Another unhealthy market behavior is apparent lack of concern for actual earnings or valuation in stock prices, and the fact that volatility has compressed to abnormally low levels. Volatility is cyclical and mean reverting, and currently the VIX is at 14.01 when its (recent) historical levels are higher at closer to 17.5. It is important to note that while we are calling for caution, we do not see a sustained or sharp bear market or recession on the horizon. Our targets for the year are unchanged, and in-line with current levels of the market.
The rates market is going to get more interesting as the Fed changes its stance. Hopefully, we will see a reflation begin that will allow rates to begin moving up from their abnormally low levels. Currently the yield curve is still inverted, but should we see inflationary pressure begin to build, long rates will rise and for now it appears the Fed is going to be holding short-term rates low. This will have the effect of steepening the yield curve, and restore more normal conditions in the pricing of money, which is a very informative way to view interest rates.
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