0.5% – Long awaited rate cut

‘Please Jay, for God’s sake, please!’

Suspense is finally over, as FED’s The Federal Open Market Committee (FOMC) held meeting on 17-18th September and as widely expected, made first rates cut since July 2023, joining in this manner to other central banks across the world. But FOMC made it in a little bit higher manner than expected. While economists predominantly predicted 0.25%, some Congress members even wrote formal letter asking for 0.75%. At the end we received 0.5% instead, with FOMC past meeting minutes and Chair Jerome Powell clearly indicating rate cut cycle to continue in 2024 and 2025. After months of market participants commenting, discussing or even begging, we finally have it.

---

But what meaning 0.5% does have and why FED decided for such rather significant cut at the beginning of cycle? Interesting, especially since US GDP was growing at approx. 3% so far this quarter, so it didn’t feel that economy would need this size of stimulative cut.

It looks like FED’s decision seemed to be driven by two factors – which Chair Jerome Powell laid in his decision announcement. One of the drivers were couple last employment reports. As we indicated in the past in our ‘Merry Crisis and a Happy New Fear’ analysis, monthly employment data were reported in overly optimistic way, only to be revised down some time later. And such was happening since quite a long time – over the year. As a result, significant revision has been made, which made employment figures look less optimistic. There also was an announcement on job growth – less 800k jobs.

Another driver was official inflation figures which worked its way from June 2022 tops, down towards (but not yet at) FED assumed targets at 2%. But as we remember, this started to develop earlier already.

According to the released minutes of FOMC meeting held July 2024, both FED hawks and doves agreed that current at a time real funds rates were at restrictive level and wanted FED to lower the rates. This could be interpreted as doves pushing towards first cut already in July, but more hawkish FOMC members prevailed, keeping rates unchanged until September. Main driver supporting this course of action were reasonably good figures coming from economy. However, since then, even despite of GDP growth which remained at approx. at 3%, retail sales weakened. Such could be perceived as result of persistently hungry inflation biting into the wallets. Hence to maintain GDP growth, FED decided to make a cut.

On how and when possibly

We mentioned earlier on restrictive rate levels. So, what could be possibly understood as neutral to economy rate levels? Or let’s rephrase above question - how low we may go in search of such? There are lot of discussions on the subject as there is no specific formula to be used, and opinions vary depending on approach on monetary policies. However, there is very strong voice (more like guestimate, due to variety of constantly changing economic factors that need to be considered), that currently approx. 2.5% would be such. Hence possible reaching levels close to such could be indicative to possible bottom of rate cuts cycle. Above is made with strong assumption, or even certainty, that we’re not going back to near-zero interest rates anymore. Point is however, whether we’d assume neutral rates at 2%, 2.5% or even 3.0%, 5.5% that marked our peak was way above that level. This means FOMC has lot of space to execute cuts, accordingly to developments in economy. Although Chair Jerome Powell emphasized clearly, that US economy remains strong, and there is no rush on further easing like every single month. He also emphasized that 0.5% less cannot be considered as a new pace.

And so, markets received long awaited cuts and promise of further ones to occur, however just not at a speed they might’ve hoped for. Hence, instead of expected less 1.25% by the end of 2024 we may get 1.0% instead. Markets consider this as slightly hawkish approach. But let’s not forget that FOMC is data dependent and will base its decision on economic projections and variety of data-based reports. Just example of CPI reports proved, datasets may be overly optimistic, like it happened in case of CPI.

So how possibly FOMC may deliver rate cuts? We won’t get any in October as FOMC doesn’t hold meeting just ahead of US elections looming on beginning of November, hence will avoid accusations of indirect interfering. And apart of getting new president, country will also choose total of 468 seats in the Congress (33 in Senate and all 435 in House). With exorbitant polarisation in society, this most likely will bring results in red or blue (colours attributed to Republican and Democratic parties) wave rumbling across United States. As winner may take it all. Further FOMC meetings are planned on 6-7th November and 17-18th December, hence Federal Reserve will be able to operate based on two additional months of economic data, especially related to labour market and possible data revisions. We have reasons to believe that next labour report will dictate next steps, and all we can do until then is to stipulate.

However, upon analysis of how individual FOMC members voted for and against cuts, and at what size, seems that average by the end of the year would be at 0.95%, which brings us closer to 1% than 1.25%. Also of total 17 voters, only 8 were supportive to three rate cuts - here median is basically at the middle. This may most likely result in 0.25% each in November and December or less likely in one strong cut this year at 0.5% to occur in November. After significant acceleration, Federal Reserve may therefore aim to slightly depress pedal, which in result should give them more data-based flexibility and control over next 6-12 months during which we should expect rate cuts. This approach is aimed to manufacture potential ‘soft landing’, avoid fuelling inflation, to reduce risk of recession and bigger increase of unemployment rate.

We’ve referred to Jerome Powell’s post decision conference and FOMC minutes. Let’s not forget however that Jerome Powell holds position of Chair in most important central bank in the world, managing most important and internationalised currency in our planet and tries to manage the most, or at least one of the most important economies worldwide. This is also home to vast majority of high market cap worldwide recognisable entities and most important equity markets in the world. US treasury papers are also most recognisable asset among whole debt market. Hence, the way he communicates with press must remain clear, reassuring confidence and most definitely not to cause fear or panic.

Is the sky’s falling on our heads?

Usually in anticipation of cuts markets tend to rally, as all market sometimes need is just to maintain optimism. After all, developed and mature markets have a natural tendency to go up long-term. But upon reception of actual cuts, markets typically tend to correct. And this is when usually gates of hell open and unleash variety of apocalypse prophets:

• ‘Oh no, they’re cutting, so that means we’re closer to recession!’. No, not really.

• ‘We have dumped hard on every rate cuts!’ No, not really.

• ‘FED is late!’ Well… it’s data based, not wishful thinking based, so no, not really.

• ‘Sky shall be falling on our heads!’ Well… actually can’t exclude this one.

---

Let’s get it straight – some sort of recession cannot be excluded in the near future. However, cutting rates is not that simple as some commentators would like it to be. On 1st of December 2008 we were at 1%. On second February 2009 we received a cut that brought us to 0.25%. This extraordinarily low level remained unchanged until 16th December 2015. Since then, FED started cycle of increases which peaked at 2.5% and remained since 19th December 2018 until 31th August 2019. In 2019, USA and China were engaged in a “trade war”, and FED was concerned that this conflict would harm the economy and push up unemployment rates. Three modest rate cuts in the second half of 2019 reduced rates to 1.75% had a positive effect on the economy. But then we experienced Covid-19 pandemic, global lockdowns, fear on unknown, alarming reports etc. In March 2020 FED made two cuts in attempt to keep economy running, which brough interest rates yet again to 0.25%. This persisted until 16th March 2022, when FED made first rate growth, as full effects of liquidity injections and ‘helicopter money’ made central banks across the globe to fight hydra of inflation. Conclusion – since February 2009 we have experienced basically only flat levels or rate increases. The only cuts we had at the time, were successfully stabilising effects of trade war. Which very soon has been forgotten as more epic in scale events occurred, and they required extraordinary measures. Hence, many investors or commentators simply never experienced real rate cuts…

That was just a brief on modern history, but let’s take a look on historical data. Of the last fourteen rate cut cycles, it is ten that directly led to a recession. Actually, let’s make it nine, as 2019 cuts didn’t cause recession in effect, it happened due to global black swan event following. So, the only times cuts delivered soft landing were 1966, 1984, 1995, 1998, and 2019, when the economy was noticeably stronger than it was today. That meant less debt, better GDP growth, more savings and reduction in unemployment, rather than an increase like we're seeing today.

---

Rate cuts are not equal – and we do not mean size, but simply background related factors and timing. What differs i.e. year 2007-2008 from 2024 is that in 2007-2008 cuts were responsive, reactive to fast pace occurring events, which was biggest bubble bursting since nearly 100 years, and which affected whole world in one way or another. While in USA it was housing market in the epicentre, in European union it has turned onto eurozone crisis. And therefore, cuts at a time were late. But drawing conclusions from 2008 about the need to cut fast today to avoid the risk of a precipitous drop in growth is missing the big picture. Rate cut we occurred seems to be proactive, monitored and most importantly is not happening after signs of recession or market crash.

Historically, initial rate cuts commencing cycle are perceived by markets as indecisive as they just cannot position themselves in between ‘imminent recession’ or ‘bull market’. Real deciding factor is ‘whether economy goes towards recession or not’. So having ‘soft landing’, ‘no recession’, and rate cuts seems to be very good combo. But if markets start perceiving economy as subject of slowdown, then fear occurs. And we cannot exclude entirely scenario, in which we’ll see some sort of slowdown developing within next months, which may transform into recession in some mild or not form. So, simply, if economy will show no weakness, bull market (either run by AI or any other narrative), has chances to be prolonged.

So what factors markets would take under consideration? There are definitely few. But let’s exclude potential black or grey swans and focus on facts and numbers.

US Federal Government runs on deficit equalling 7% of GDP. OK, maybe 7% is not exorbitant figure, but if translated to dollar terms, then definitely is. Such simply was supportive to positive GDP growth. After all, what is GDP? Gross domestic product is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time. Hence injecting liquidity onto certain sectors acquired by debt sale, contributed to US economy growth. Real GDP growth in Q2 2024 was at 2.6%, but then has been revised to nearly 3%. Which is well above the 1.2% that is typically experienced in a recessionary scenario when the Fed cuts. And that’s one of the reasons to observe what is happening to a government debt and how markets perceive it. Even despite fact that it is US debt, and not some garbage CCC rating bond issuance, certain level of general volatility is to be expected.

---

Speaking on bond market reaction on interest rate cut. Normally bond yield would be declining, however US10y are now at 3.76% and US2y at 3.54%. Especially long-term yield started to grow. Cut by 0.5% might’ve been indicative to bond holders that US economy may not become as weak as expected. With promises of further rate cuts, US economy may receive further invigorative injections, but that may also become fuel to inflationary tendencies. Inflation of course has bottomed out, but didn’t reach FED assumed targets at 2%, so if trend on cuts will be continued, it may simply plateau at just slightly higher level as we’ll get to i.e. middle of 2025 or later. It will be very interesting on such, if FED will again play ‘no one saw that coming’ card, while politicians will use ‘fault of usual suspect’ argument. But with such, question that bond holders may now ask themselves is, ‘do I want to commit myself to bonds in such situation’. And answer ‘yes’ may be given only if yield would deliver higher than inflation.

It may be interested also in different context - since peak inflation in US at 7.1% occurred in June 2022, it supposed to be followed by similarly powerful deflationary impulse.

Few words on other important factors – retail spendings and unemployment

Unemployment rate soared during most heated time of pandemic to 14.8%. But by mid-fall 2021, unemployment had fallen below 5%, close to most economists’ estimate of maximum employment. It continued to decline into 2022. Eventually it crept up from 54-year low of 3.4% in January 2023 to 4.2% in August 2024. In concerning numbers, comparison of August 2023 and 2024 unemployed figures show increase by 7.1 mln people, which is 12% increase within indicated timeframe.

Labour market data shows progressive slowdown in job creation. But what didn’t happen yet, are layoffs, which is cyclical and logical another step in recurring macro cycles. Historically, going back to 1950’s, labour market follows fairly regular pattern – decreases in hiring, and when economy slows down, finally layoffs. If it happens, may be indicative that we may expect some sort of recession. In this context, yield curve has not been that negative in any historical moment of modern US economy. By the way, for now again it’s not. So historically there was a very tight correlation between economic behaviour relative to how long yield curve remained inverted. Each occurrence ended with some sort of recession.

---

Currently personal savings rate is a mere 2.9% for Americans, indicating they are spending beyond their means. Americans’ total credit card balance is 1.142 trl in the second quarter of 2024, according to the latest consumer debt data from the Federal Reserve Bank of New York. That’s up from 1.115 trl USD in the first quarter of 2024 and is the highest balance since the New York Fed began tracking in 1999. And as example comes from the top, the government debt to GDP is now 123% - 35.4 trl USD.

And this is where US experience historically significant bifurcation. On one end we have 40% US population that already spent / burned their excess savings and did shrink their budgets and spendings due to inflationary pressure. But on the top end, we experience rally on equity market and persistently high prices on housing market.

In this uneasy balance we’re approaching holiday season. Estimated 3 mln people flew last year across state or states to sit with family and eat Thanksgiving turkey in United States. Then in a couple of months we’ll experience Christmas. Holiday spending along with grocery and services will be another indicator to observe, which should tell a lot on condition of US economy in comparison to previous years. As if Americans were to suddenly decide to save closer to their long-term average, or the government debt simply decelerated in its growth trajectory, there could be a big downward effect on spending and GDP.

What all this means for precious metals?

Precious metals are one of the top-notch asset class for 2024. Both gold and recently silver outpaced SP500 return ratio-wise in current year. After all, upon realistic and priced in expectations on rate cuts, currencies weaken, hence precious metals should grow in nominal terms. Not only did the Fed's 0.5% rate cut send gold to a record high above 2.6k USD but it also sent US dollar sinking below 0.85 Swiss Francs, a new 13-year low. Pound Sterling equals 1.33 USD, Euro equals 1.11 USD. Considering that BoE, ECB, PBoC and others already made cuts, gold once again makes important levels and breakouts in various currencies – one such example is XAUCHF pair. With very supportive macro conditions, precious metals seem to be on a right track.

---

Gold makes new price records basically, day after day, however recently experienced very shallow correction upon interest rates decision which could be considered as key reversal day. On 18th September It made higher high and lower low. Over the course of last year, each time gold experienced such price pattern has marked short term price high which has been followed by correction. Hence, we may experience interesting buying opportunity. Price run simply would need a moment to gather more steam for further growths, which later should push us even higher than end of September 2024 highs.

Silver has been lagging gold in terms of price action, but recently made a firm move over 32 USD price levels. White metal experienced 4th consecutive year of imbalance between supply and demand (approx. at 200 mln ounces) and had to be drawn from warehouses in attempt to fill the gap. Approx. 70% of silver is being used by industry, that is windmills, solar panels, electronics, etc. In described occurrences, silver has a lot of upside potential but again, just like gold, may be vulnerable for temporary pullback. Assuming we predict correctly direction for gold, this would mean even stronger silver rally.