September 2024

The narrative as we closed out the third quarter was that the economy had weakened enough that the Federal Reserve would need to trim the overnight lending rate by an additional 50 basis points this year and that rate cuts would continue through next year, with the ultimate target of getting to 3%.

That assumption was derailed by the September employment report which showed 254,000 new jobs created in the month.  The consensus expectation was 150,000 new jobs, with the outcome surpassing even the highest forecast of 220,000.  The household employment measure was even more robust, showing job gains of 430,000, causing the unemployment rate to fall to 4.1%, or an unrounded 4.051%.  Average hourly earnings rose 0.4% month over month.  All said, it was a blockbuster report.  A skeptic might suggest that such an outsized number, coming weeks before the Presidential election was somehow tainted, but the markets reacted accordingly, with rates moving higher and the yield curve flattening.

Following the decisive cut in Fed Funds, Fed speakers muddied the water with conflicting descriptions of the economy.  Chairman Powell said the economy is in “solid shape” at a speech, while emphasizing that more rate cuts are anticipated.  At the other end of the spectrum Chicago Fed President Austan Goolsbee, sounding more pessimistic than the Chairman, said that rates must fall by “a lot” over the next year.

Thoughts on the economy and the trajectory of interest rates have morphed since month end with equity investors anticipating that the Fed will follow through on their economic projections and the path of interest rates, while fixed income investors seem a bit more skeptical.  Specifically, the 2-year note is nearly 50 basis points higher in yield than the low touched at the end of September, while the S&P 500 continues to push in to all-time high territory, seemingly daily.

That price action is likely to back the Fed into a corner.  The premise for the stock rally is that lower rates will result in higher earnings, thereby increasing the valuation of the individual companies overall.  If the Fed doesn’t deliver the anticipated rate cuts, then companies will be deemed overvalued, and the market will need to correct lower.

The conundrum is that the next President, whether Democrat or Republican, is likely to accelerate spending to “juice” the economy, which historically has been inflationary.  With the risk of inflation rising, the Fed is likely to be reluctant to cut rates to the degree that their forecasts present.  The key to sustaining the stock market rally is for deficit spending to boost profits; offsetting the drag from higher than anticipated interest rates.

That dilemma was on display as the minutes of the September Open Market Committee meeting were released.  The minutes portrayed the committee as being split on whether to cut the overnight rate by 25 or 50 basis points.  In the circumstance of accelerating economic activity the reluctance on the part of the rate “hawks” is likely to rise.

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