Be Careful About What You Ask

by: Kenneth J. Entenmann CFA®, September 6, 2024

The markets have been sending conflicting messages. The bond market has seen interest rates plummet, and the yield curve flatten based on a heightened concern of economic slowdown and even, dare I say its name, a recession. Yet, at the same time, the equity markets are trading at record highs, convinced the Fed has stuck the soft landing. Both cannot be true.

Driving both markets is the belief that the Federal Reserve Bank is about to embark on a quick and significant interest rate cutting cycle. Even the Fed talking heads have indicated the rate cutting will begin in two weeks. The only question is how much rate cutting will occur. This has led the markets to conclude that the Fed will aggressively cut rates, starting with a 50-basis point cut in September, quickly followed by additional 75 basis points through 2024.

This morning, the Dept. of Labor released its all-important employment report. It was a mixed report, providing fuel for both pessimists and optimists. The non-farm payroll number was 142,000, pretty close to expectations. The unemployment rate decreased to 4.2%. The decline in the rate was due to changes to the Labor Participation Rate which increased by 120,000. Lastly, average hourly wages increased by .4% in August, and 3.8% year over year.

The 142,000 non-farm payroll number provided fodder for debate. Indeed, the payroll number, combined with downward revisions for June and July, provide evidence that the labor market is “cooling,” and a sign of a slowing economy. I would suggest that the labor market is “normalizing.” A monthly increase of 142k jobs is close to what is historically average rate of growth. However, the average hourly earnings number of 3.8% YOY hardly suggests wage inflation is dead. Yes, payroll numbers are slowing back to “normal,” but wage inflation is sticky. Is this a reason for the Fed to be “aggressive” with rate cuts? After the report, the expectation for a rate cut in September is now 100%. There is a 50%/50% probability between a 25 or 50 basis point cut.

Calls for recession have been around for the last three years and have failed to materialize. Yes, the economy is slowing, but from a robust level of 2.8% in the 2nd quarter. Small businesses continue to have difficulty finding new employees. At NBT Bank, our loan demand and credit quality remain strong, hardly a sign of recession in our geographic footprint. Inflation continues to recede, but also remains stubbornly higher than the Fed’s target. Consumer spending is slowing, but from torrid levels. Signs of imminent recession are hard to find.

I believe the markets should be careful with expectations for rate cuts. This economic environment is hardly a reason for the Fed to depart from its slow and methodic policy process. I fully expect the Fed to cut interest rates by 25 basis points. I would be surprised if they cut by 50 basis points. It would be a significant departure from their policy routine and may even send a message of panic, something the Fed desperately would want to avoid. Looking through 2025, the markets are calling for 6-8 rate cuts. Be careful, the last time interest rates were that low we experienced a financial crisis (2008) and pandemic (2021). The bond market is forecasting a recession. I am sorry, I have a tough time hoping for recession. More importantly, a slowing economy does not mean a recession is imminent or inevitable. The equity markets are hoping rate cuts may support higher valuations. Indeed, the S&P 500 index trades near its historic high, but so is its P/E. Hoping for significant rate cuts to justify that high valuation may not be a great long-term strategy. If the Fed fails to deliver on the significant rate cut expectations for 2025, the equity market may be susceptible.

Be careful about what you ask! I am not sure I want to live in a world with extremely low interest rates! Usually, it means bad stuff has happened, as our recent experiences have demonstrated. Be careful about what you ask!