The ABCs of easing cycles: Anything But Cash 

Our September Investment Quarterly (IQ) was held in London a day after the Federal Reserve (Fed) cut rates for the first time since March 2020. The Fed beginning its rate cutting cycle was not particularly surprising. What was surprising were the press reports a week earlier, during the Fed’s blackout period (when members cannot speak to the media), that had the effect of guiding the markets to expect what would be the eventual 50 basis points (bps) reduction—as opposed to 25bps, which had looked carved in stone. 

While Fed Chair Jerome Powell’s press conference remarks gave a very balanced view of the rationale for the 50bps rate cut, the markets will continue to debate in the weeks ahead whether something more significant is occurring or if this is really a simple, in the Chair’s words, “recalibration.”

The IQ participants spent much of the day poring through data and identifying what had changed to justify the Fed’s larger rate cut, and whether the U.S. economy was as well balanced as Chair Powell portrayed. Certainly, inflation and the labor market had moderated further in recent months, but broad measures of economic activity continue to remain healthy. 

Had the Fed waited too long to reduce some of the funding pressure on businesses and households? Or was there enough underlying strength in the U.S. economy that an aggressive easing cycle would lead to a resurgence in growth and inflation? Complicating the picture were a range of policy divergences globally. China and Europe were struggling with weak growth, while the UK was still battling sticky inflation and Japan was in the midst of a hiking cycle.

The one thing the group did not want to lose sight of is that the beginnings of Fed rate-cutting cycles are always met with market euphoria—no matter where markets land in the end. Since our June IQ, most bond markets had risen by 4%–6%, and we expected something similar over the next three to six months. As returns on cash sink, the ABCs for investing during this part of the cycle are “Anything But Cash.”

Macro backdrop

The Fed has done very well in cooling off a supercharged economy following the COVID stimulus bills, and in bringing the economy back in line with their dual mandate of price stability and full employment. By the time of the rate cut, their preferred measure for inflation, core personal consumption expenditures (PCE), had declined to a three-month annualized run rate of 1.7%, down substantially from 6.6% in 2021. The labor market had also cooled off, as unemployment had risen from a low of 3.4% to a recent high of 4.3%, and payrolls growth had slowed from above 200,000 a quarter ago to a three-month moving average of 116,000, as of the August report. 

The only problem was that while inflation and the labor market were now in good balance, the fed funds rate was still at a highly restrictive level and a far distance from around 2.9%, which both the Fed and the markets assume to be the neutral rate. Perhaps the Fed had waited too long to ease, and the pressure on businesses and households would continue at a pace that would lead both to pull back on spending and, eventually, to recession? There is ample evidence that the housing market was weak and small businesses were suffering—both signs of high funding costs. Perhaps it was the rapid rise in unemployment triggering the Sahm rule1 that led Chair Powell to unexpectedly shift from a 25bps to a 50bps rate cut.

On the other hand, the IQ group was also concerned that the underlying strength in the economy was still evident and 50bps in rate cuts may have been too much, too soon. The Atlanta Fed GDP tracker was indicating that 3Q GDP would come in at 2.9%. We continue to see money from the full range of COVID stimulus bills (American Rescue Plan, Infrastructure & Jobs Act, Inflation Reduction Act, CHIPS and Science Act) being distributed. And a look at corporate earnings and consumer loan payments suggested that while some pressure was there, nothing particularly troublesome was evident. Also, absent were any potential crises in the emerging markets or U.S. municipalities—traditionally soft spots following aggressive Fed hiking cycles. The balance sheets for businesses, households and state and local governments seem to be in good shape, with only sovereign balance sheets looking overleveraged (but does that matter anymore?).

Perhaps Chair Powell is correct, and the U.S. economy is about as well balanced as it can be at this stage of the cycle. What is clear to us is that the Fed and the other central banks, and the extent to which they can maintain the current balance, are the keys to ensuring the first soft landing since 1995. 

We believe the Fed can bring rates down to a range of 2.75%–3.75%. That, admittedly, is quite a wide range, but the terminal fed funds rate will be dependent on the pace at which they cut rates, and the extent to which the economy responds to that policy action. The other important consideration would be any policy actions following the U.S. general elections that altered the current trajectory. 

Scenario expectations

Like the Fed, the group had to acknowledge that the labor market had weakened more than expected. We also had to balance that with the 50bps rate cut in response. After much discussion, we lowered the probability of Sub Trend Growth/Soft Landing by 10%, to 60%, and increased by 5% both Above Trend Growth (to 20%) and Recession (to 15%). While Soft Landing remains our base case, we appreciate that a fast moving Fed is a sign that policymakers may have either waited too long to cut rates or are cutting too aggressively. We will have time, over the next couple of quarters, to see the speed of the transmission from monetary policy to business and household behavior. 

While it was tempting to reduce Crisis to zero, the U.S. elections loom large, so we kept the probability unchanged at 5%. Policies resulting from either party sweeping the presidency and Congress could be aggressive. Additionally, the assassination attempts are a threat to stability.

Risk

The risk to our soft landing expectation is a sharp reacceleration in growth and inflation that would cause the Fed to under-deliver in this easing cycle and reverse course. A unified Congress under either a Harris presidency or a Trump presidency would come with promised tax cuts and increased spending. It’s as though the level of sovereign debt is no longer an obstacle to fiscal stimulus in the eyes of politicians, regardless of party. 

Despite the softening in the labor market, we are less concerned about the risk of recession. We know the Fed and other central banks have a lot of tools at their disposal to reinvigorate growth.

Strategy implications

The IQ group was overwhelmingly biased toward ideas that would benefit from proactive central bank easing. Carry-oriented ideas and yield curve steepeners dominated our best ideas. High yield, especially CCC rated credits, were a favorite, as were bank loans, convertible bonds and additional tier 1 (AT1) securities. Stable and still relatively high margins, and the potential for renewed top line growth, should be very supportive to corporate credit. 

Given the record high in money market fund assets, they also gravitated to a market that has gone largely unnoticed over the last couple of years: emerging market debt. There was a belief that money would search not only for yield but also markets that had lagged or been left behind. Local emerging market debt, emerging market currencies and emerging market corporates all received considerable support from the group. High real yields, an overvalued USD and stable economies make the asset class compelling. Securitized credit also remains a staple in our portfolios. Consumer loan performance looks fine and Fed rate cuts will be a nice tailwind to the consumer.

Closing thoughts

Until the week before the Federal Open Market Committee meeting, we didn’t think we would see a 50bps rate cut. But here we are, and now all those with cash on the sidelines will face major FOMO (fear of missing out). Historically, once the Fed starts cutting, cash is liquidated in earnest and flows into all markets … but mostly into fixed income. We still see plenty of value across a lot of markets, so Anything But Cash is our mantra into the elections and year-end.

¹ The Sahm Recession Indicator, named for economist Claudia Sahm, signals a recession when the three-month moving average of the national unemployment rate rises 0.50 percentage points (or more) relative to the minimum of the previous 12 months’ three-month averages.

0903c02a81d2d0a6