Fed trims rates—what next?

Fed kicks off easing cycle

The Federal Open Market Committee decided to lower the Fed funds rate by 50 basis points¹ (bps) on Wednesday, bringing the U.S. policy rate to between 4.75%–5.00%. In addition, the rate-setting committee also suggested that we could see another 50bps of cuts in 2024, more than previously forecast.

The committee’s Summary of Economic Projections (commonly known as the dot plot) lowered U.S. inflation and GDP growth forecasts for this year while raising its unemployment rate forecast to 4.4% from 4.2%. 

Stocks initially rallied on the report (particularly riskier areas such as small caps) then erased gains after U.S. Federal Reserve (Fed) Chair Jerome Powell cautioned against assuming more 50bps cuts are coming. The U.S. dollar rose and bond yields backed up modestly but experienced limited volatility as the dot plot was relatively in line with the market’s expectations for roughly ~100bps in rate cuts this year in total.  

What happens next? Three factors to watch:

Now that the cutting cycle has begun, what’s next?  To us, the Fed’s going to need to focus less on its inflation mandate and more on its employment mandate going forward if the central bank wishes to maintain a soft-landing scenario for the U.S. economy. There are three keys, in our view, for a continued soft-landing economic backdrop:

1. If you’re not easing, you’re tightening―The bond market has already priced in 2.5% in rate cuts over the next 12 to 16 months.² If the Fed chooses to cut less than that, it would in essence be tightening monetary policy relative to what the bond market has already baked in. Past rate-cutting cycles have seen a significant amount of cutting (on average 5% in total over the last 50 years) and that is usually with recessions. To avoid a recession, the Fed will likely need to cut rates but do so at least in line with bond market expectations.²
2. The jobs market needs to hold steady―The Fed doesn’t want any further softening of the labor market. The unemployment rate typically hits 5.1% in a hard-landing scenario; we’re currently at 4.2%.² Initial jobless claims are the timeliest labor market indicator, and the Fed will need them to stay relatively low to keep a soft landing. As of the last week, they were at 230,000, nudging lower after hitting 250,000 in the summer.²
3. Liquidity conditions can’t dry up―Borrowing costs for lower-quality companies have been falling with the overall high-yield corporate bond yields at 7.30%, the lowest level since mid-2022. The spread on high-yield corporate bonds relative to U.S. Treasuries is 3.12%, a historically tight level.² We see this as reflective of a favorable credit backdrop, but this could change if investors/traders lose confidence or if we experience an exogenous shock. For now, we think credit conditions are helping the economy stay stable.

Hard landing vs. soft landing: investment implications

Should initial jobless claims and high-yield spreads stay low, the economy should stay in a soft-landing regime. In our view, the investment backdrop will continue to be favorable toward higher-quality bonds and stocks given that inflation likely continues to decelerate, and we will still be in the midst of a rate-cutting cycle.

As we see it, how stocks and bonds are likely to perform in a hard-landing or a soft-landing scenario could make allocation and positioning decisions challenging. Bonds will likely do better in a hard landing, stocks better in soft (although both asset classes are likely to do well to some degree in a soft-landing scenario).

In our view, sticking with the higher-quality bias makes sense across stocks/bonds and keeping a relatively neutral stance―with even a modest bond bias―on stocks/bonds allocations for the time being.