Why rate cuts could be the next big market risk
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Investors got their interest rate cut wish in September. The market is now pricing in more than 100% odds of another cut this year, after private data indicated further weakness in the labor market.
Why it matters: Investors are expecting more rate cuts even as there's evidence that the economy is reaccelerating. Additional rate cuts could fuel a new leg higher for stocks — or it could stoke inflation as well as investors' fears of a market bubble.
What they're saying: "I've been describing myself as uncomfortably bullish" Michael Arone, chief investment strategist at State Street Investment Management, tells Axios.
- "The Fed could be cutting rates too aggressively at a time when the economy and labor market could be stronger than feared," he says.
Threat level: He sees two risks associated with overly aggressive rate cuts.
- Trimming rates amid an economic expansion could create the beginning of a "new bubble," with valuations stretching from already elevated levels.
- Bond vigilantes could emerge if inflation reaccelerates. If they were to sell off their bond holdings and push up yields, those higher yields could attract investors, drawing buyers away from the stock market.
Yes, but: When a rate reduction follows a pause in the Federal Reserve's cutting cycle, that has typically been bullish for risk assets, notes Chris Galipeau, senior market strategist for Franklin Templeton Institute.
- The Fed waited nine months to reduce rates after its December 2024 cut
By the numbers: On average, stocks rise 17% a year after the Fed resumes cutting following a pause. The Nasdaq gains 25%, and the Russell 1000 rallies 14%, over the same period, according to Franklin Templeton's data.
- When stocks are at record highs and the Fed cuts, stocks are up by double digits on average a year later.
Between the lines: How do you determine whether a rate cut is a risk or a reward for your portfolio? Look at the 10-year Treasury yield, State Street's Arone says.
- If yields drop sharply, that could indicate the economy is in trouble, while if yields stay above 4%, that's a sign of economic health.
- If the Fed is cutting because of fears of a recession, that's bearish.
- This time, the central bank is cutting into an expansion, Galipeau says, adding that's happened only six other times in history, leading to outperformance for stocks on every occasion.
The bottom line: "The U.S. economy remains remarkably resilient, and it is becoming increasingly difficult to argue that we are still waiting for the delayed negative effects of what happened six months ago on Liberation Day in April," wrote Torsten Sløk, chief economist at Apollo Global Management.
- "For investors, this means that the upside risks to inflation are growing, particularly if the Fed continues to cut rates," he added.
My thought bubble: If inflation reemerges while the Fed is easing, it could create a Goldilocks backdrop for earnings growth — one that supports record valuations and fuel further gains in the stock market — as long as bond vigilantes are kept at bay.
