Mr. Powell’s Pivot, And The Promise Of A Soft Landing

The S&P 500 and Dow rallied to all-time highs this morning in response to yesterday’s interest rate cut by the Federal Reserve. (see below). Several sectors are up more than 1% in early trading, including consumer discretionary, energy, industrials, technology, communications and materials. The bond market is mixed, with short-term issues rallying but long-term bonds trading flat-to-down.

The Federal Reserve announced a major change in policy yesterday, cutting the Fed-funds interest rate by .50% and pledging to “recalibrate” rates back to normal levels. Fed Chair Jerome Powell said that while his “patient approach” in fighting inflation over the past two-and-a-half years was correct, it is now time to pivot because inflation is under control. He noted that the economy continues to grow at a solid pace even though the job market is slowing. Many economists believe this last point is precisely why the Fed cut rates by .50% vs. the usual .25%. in other words, the risk of further job market deterioration is now higher than the risk of re-igniting inflation.

Recall that the Fed embarked on a “tightening cycle” in March 2022, taking rates from near zero to 5.5% by July 2023. Then they pivoted to a neutral stance, holding rates steady as inflation gradually declined. But everyone knows that the economy can’t handle elevated rates forever, and we’re now seeing some cracks. So with the first rate cut in the books, today’s media debate centers on whether Mr. Powell’s jumbo .50% cut means he’s worried about getting a late start as growth falters. In other words, has his patient approach to rate cuts already spoiled the coveted soft landing?

We don’t think so. As Mr. Powell puts it, this “good, strong start is a sign of our confidence.” He noted “resilient” consumer spending and also said corporate capital spending is beginning to pick up. He sees the labor market—which was clearly overheated in 2021 & 2022—returning to more normal pre-Covid levels. He clearly believes inflation has been beaten without too much collateral damage to the economy. In fact, Fed economists predict economic growth of about 2% through 2026. So he’s got the luxury of returning interest rates back to “neutral” on his own timetable.

What is neutral? Mr. Powell’s new Fed-funds target rate is 2.9%. That means he has another two percentage points—or 200 basis points—of cutting to do. And while he’s cagey about predicting the pace of cuts going forward, bond market trading activity suggests it could happen over the course of 12 months.

Lower interest rates are expected to boost profitability and financial flexibility for Corporate America in general, and housing stocks in particular. Interest rate expectations have been falling in anticipation of this change in Fed policy. According to Bankrate.com, the average 30-year fixed mortgage rate has fallen to 6.6% from 7% at the beginning of August. Not surprisingly, mortgage applications jumped last week and both building permits and new home construction activity continue to improve.