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Investment Note #10

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Synopsis

  • In recent times the buoyancy of public equity markets has been supported by two key factors. Firstly, the emphasis on US tech stocks, especially those centred around AI, and secondly, the anticipation of more accommodative monetary policy from central banks in 2024.

  • AI related discussion probably gets more attention, so we thought in this note it was worthwhile to look at what might destabilise the consensus surrounding the timing of interest rate cuts in the US.

  • One issue of potential concern is whether the data and the 2024 calendar will cause Jay Powell and his fellow Federal Open Market Committee (FOMC) members any issues. The Fed has signalled that there will be no rate cut next week (20th March). Therefore, what happens if inflation data is inconclusive in May/June, which is a reasonable scenario, given the strong current economic and employment background in the US. Could this mean that the Fed must navigate commencing the rate cutting cycle during the US election period and what, if any, influence could this bring to the decision making process?

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Diary Clash

  • You know that feeling when you look at your diary and you see a calendar clash that you can’t resolve. It’s not a nice feeling and it may be one that Jay Powell will begin to feel later this year.

  • There is a complacency creeping into markets, that 2024 is the year that the Fed commences its rate cutting cycle. It’s a reasonable assumption and one that is largely based on guidance that the Fed itself has provided. Through the Summary of Economic Projections, better known as the ‘dot plot’, FOMC members give insight into the expected course of interest rates. The fact that the Fed has already announced that the cycle of rate cuts will commence this year, means that it will be extremely tricky not to deliver the 75bps they have guided.

  • Therefore, it is entirely reasonable for the market to think that we are going to have rate cuts because that is explicitly what the Fed has guided. The stock market doesn’t want to get bogged down in whether it's March, or May or June, the Fed has said there's going to be rate cuts. So just price in rate cuts.

  • The Fed has been fairly clear that it will not be cutting rates in the March meeting, so all eyes will be on May and June. But this is where the calendar potentially starts to work against Powell.

Political Interference

  • Central Bank independence is a key aspect of modern central banking and has its roots in the recognition that monetary policy decisions should be based on the best interests of the economy, rather than being influenced by short-term political considerations.

  • This independence is created through the formal legal provisions that enshrine autonomy: mandate, organisational structure and operating procedures. But as is often said with reference to how justice needs to be seen to be done, there is an argument that the political independence of a central bank needs to be seen to be done.

  • The Fed doesn’t want to attract any attention during what is likely to be the most divisive US presidential election ever. We know from experience that Trump will not be reluctant to call out the Fed’s actions, if they provide him with any cause to do so. Indeed, George Bush Senior, famously blamed Alan Greenspan for his 1992 election defeat as he believed Greenspan should have cut rates more rapidly during the recession of 1990-91.

  • As we get closer to the election, the Fed will increasingly want to avoid being part of the narrative. There is also precedent for this. The first post 2007-08 financial crisis rate hike took place in December 2015 and the 2nd was in December 2016, one year later. Between these two hikes there was a presidential election. There is a strong incentive for the Fed to stay on the sidelines and to avoid becoming part of the narrative.

May/June Fed Meeting Considerations

  • If the data doesn’t support a rate cut in May or June, then attention moves to July and that’s when things could potentially become tricky. The commencement of a rate cutting cycle would be a significant signal to the market. It would provide confirmation that we have entered the next cycle in monetary policy. Given we have just gone through an unfamiliar period of higher inflation; it will also be interpreted as the Fed confirming that inflation has been tamed. The first rate cut is much more significant than subsequent rate cuts.

  • If the data is inconclusive, will the Fed be tempted to cut anyway? Could the argument be that they should just kick the rate cutting cycle off and allow subsequent data to drive the pace of rate cuts?

  • It may be tempting. However, lurking in Powell’s mind will be the legacy of Arthur Burns, Fed chairman for most of the 1970s, who plays the role of antihero in most stories about inflation in the 1970s. Burns is characterised as indecisive and lacking courage in his failure to conquer inflation and compares unfavourably to the almost iconic status of Paul Volcker who did what was needed to bring 1970s inflation under control.

July to November: A Political Minefield

  • The July meeting sits between the Republican and Democratic national conventions. If the Fed decides to start cutting the week after the Republican Convention, the Republicans are quite likely to accuse Jay Powell of trying to rig the system to elect Biden. Equally if the economy is weakening into July, and he cuts rates, then the Democrats are likely to be unhappy with him for allowing the economy to come off the rails 90 days before the election. Everything else being equal, it’s probably better staying out of the narrative.

  • Importantly, the calendar remains tricky after that. The September meeting is two days after the first presidential debate and six weeks out from election date. November 6th, is the meeting after that, is the day after the election. This could be considered a safe day to cut rates but it could also look intensely political, because the Fed could be accused of waiting till the day after the election to act.

Conclusion

  • If we get to July without the first rate cut, it may be difficult to cut before the December meeting. If one or two cuts have happened before July, then continuing the rate cutting cycle shouldn’t be a problem.

  • Powell is probably willing the data in May/June to be supportive of starting the rate cutting cycle. Indeed, he may be minded to interpret inconclusive or mixed data as being supportive of a rate cut. Therefore, rate cuts commencing in May/June, as priced in by the market, seems like a sensible base case. The interesting scenario is what Powell does if the data in May/June shows strong job creation and there is a spike in inflation. Will the decision on interest rates be based on studying the data or the calendar?

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