The Fed's Ambivalence: What Investors Can Expect from Its Dovish Shift

While the Federal Reserve has kept interest rates unchanged, recently released economic data such as PCE, CPI, and the unemployment rate suggest that inflation is trending in the right direction, leading the market to believe that a cycle of decreasing interest rates will begin soon. However, the debate continues; it's not about "whether or not," but rather "when and how" rate cuts will occur.

Federal Reserve Chair Powell's recent speech at the ECB forum offered a balanced and less hawkish view on U.S. monetary policy, emphasized progress in reducing inflation, and noted that recent data suggests a return to a disinflationary path. Powell stressed the need for continued positive data before considering rate cuts and acknowledged that while a September rate cut isn't explicitly planned, the risks between inflation and the labor market are becoming more balanced. He also highlighted the gradual cooling of the economy, with steady progress on inflation, a 4% unemployment rate, and 2% growth, aligning with the Fed's goals.

It's not surprising to see Chair Powell's dovish turn as the recently released data has shown a trend of strong growth in employment while inflation is easing, a strong sign of a soft landing. The stronger-than-expected non-farm payrolls, which added 272,000 jobs in June compared to an estimated 182,000, indicate robust job growth but also a potential cooling down in hiring trends moving forward.

Additionally, the Consumer Price Index (CPI) rose by 0.3% month-over-month, aligning with expectations, but the year-over-year increase of 4.0% was slightly below the anticipated 4.1%, suggesting that inflation pressures are moderating. The unemployment rate's slight drop to 3.6% from the estimated 3.7% also reflects a stable labor market without overheating.

These factors combined suggest that the economy is stabilizing, potentially prompting the Fed to consider pausing or even reducing interest rates to support continued economic growth without the fear of runaway inflation. Such a shift would mark a dovish turn in monetary policy, emphasizing support for economic activity over aggressive inflation control.

Citigroup is forecasting quarter-point rate cuts in September, November, and December, having scaled back from an earlier projection of four cuts starting in July. The bank is closely monitoring the unemployment rate, which rose to 4% in May from 3.9% in April, and expects inflation to continue cooling. Similarly, Goldman Sachs and Nomura also predict the first rate cut in September.

On a more hawkish note, JP Morgan anticipates a November rate cut due to strong labor market momentum, reducing their expectation from three cuts to one this year. Inflation stood at 3.3% in May, moderating for two consecutive months, but U.S. interest rates remain at 5.25-5.50% since July 2023. Despite these high rates, their full impact on inflation and consumer spending is delayed, partly because many individuals and corporations secured low rates during the pandemic.

If the Federal Reserve cuts interest rates to preemptively prevent an economic slowdown, the stock market might rise because lower interest rates reduce corporate funding costs, improve profitability, and boost market confidence and expectations. Dividend-paying sectors, such as utilities and REITs, and large growth companies with stable cash flows particularly benefit from reduced borrowing costs. Historically, during Fed rate cut cycles, U.S. stocks market have outperformed other developed contries' markets, while emerging market stocks benefit from a weaker dollar and increased capital inflows.

When the Federal Reserve cuts interest rates, it typically lowers the U.S. dollar's value, making commodities priced in dollars cheaper for foreign buyers and driving up demand, leading to higher prices for gold, oil, and agricultural products. Reports indicate that metals particularly benefit from rate cuts due to lower borrowing costs and increased investment in production and consumption. Goldman Sachs forecasts a 15% total return for commodities in 2024, highlighting the positive impact of expected rate cuts on raw materials demand. Additionally, the shift towards renewable resources boosts long-term price momentum for electrification metals like copper, aluminum, and lithium, which are expected to see significant price increases due to a growing supply-demand imbalance, further amplified by falling interest rates.

Bond prices and interest rates have an inverse relationship; when interest rates fall, the discounted value of future cash flows increases, leading to higher bond prices. For example, a bond with a fixed coupon rate becomes more valuable as the overall interest rates drop, since its relative yield becomes more appealing. Research shows that during previous rate-cut cycles, longterm bond assets have demonstrated significant outperformance prior to rate cuts, followed by U.S. stocks. In the last eight cycles, U.S. Treasury yields consistently led before the Fed's first rate cut, followed by U.S. stocks. After the rate cuts were implemented, bond yields narrowed their gains.

Source: Bloomberg, Moneywise, Vanguard