Don’t fight the Fed?

The Federal Reserve started its easing cycle with a bang last week.

It cut the Fed Funds Rate by 0.50 per cent, a bigger move than some had expected.

Is that an ominous sign for the outlook, or will it be the catalyst for markets to keep pushing higher?

Central banks don’t have a great track record of taming inflation without causing recessions, but for now investors are keeping the faith.

The S&P 500 sharemarket index hit a new high the day after the announcement, while commodity prices and longer-term Treasury yields rose.

That last reaction is important, as it suggests bond markets believe policymakers are on the right track.

If longer-term interest rates had gone the other way, that would’ve been a vote of less confidence (implying the Fed would have to cut even further in the future).

Since 1990, 70 per cent of the Fed’s interest rate adjustments have been in increments of 0.25 per cent.

You don’t see bigger cuts outside of crises or recessions.

The pandemic in 2020, the GFC in 2007 and 2008, when the dotcom bubble burst in 2001 and 2002, and during the early 1990s downturn.

We’re obviously not in a crisis right now, nor is the US economy in recession.

This time the bigger move is because of a weakening labour market, with unemployment rising and signs of softness elsewhere.

In recent years the Fed has been accused of moving too slowly and being forced to chase its tail.

It’ll want to avoid such criticism again, and get ahead of any looming slowdown by acting swiftly.

The Fed’s mandate is to promote maximum employment and stable prices.

Prices look increasingly under control, with headline inflation having fallen to 2.5 per cent, the lowest since early 2021.

Despite the other part of the mandate coming under pressure, the US economy doesn’t look too bad.

Retail sales and industrial production were above expectations in August, while the latest estimates are for economic growth to be running at a healthy 2.9 per cent this quarter.

Rising unemployment hasn’t been driven by mass layoffs and collapsing demand.

Strong immigration has added to the pool of workers, while excess savings from the pandemic-era have run out and pushed people back into the labour force.

While that’s comforting, it doesn’t mean we’re out of the woods.

The Fed has embarked on ten easing cycles since 1980, six of which were associated with recessions.

It will be acutely focused on the labour market from here, starting with next Friday’s monthly US jobs report.

If we see further softness, another proactive cut of 0.50 per cent is quite possible.

The prospect of a steady decline in interest rates isn’t the only thing keeping sentiment high.

With six weeks to go, markets have also become more relaxed about the US election.

Current polling points to a Kamala Harris victory, while there’s a good chance of a Republican-controlled Senate.

Investors usually welcome gridlock in Washington, as it limits the ability of any president to make dramatic change.

Seasonality might also be on our side heading into October, as some of the typical headwinds turn into tailwinds.

Historically, the September quarter is by far the most difficult of the year for US shares.

Since 1950, the S&P 500 has returned an average of just 0.6 per cent in the September quarter, finishing higher only 61 per cent of the time.

In contrast, the December quarter has been strongest of all, with an average return of 4.3 per cent and an 80 per cent hit rate of positive returns.

We should also take note of the shift in market leadership which has been a feature of recent trading.

The last year or two have been all about the Magnificent Seven and the tech sector, but things are changing under the hood.

More recently, the strongest sectors have been utilities and real estate, while industrial stocks have also performed well.

A broadening of the rally is a good sign, although the favouritism for defensive sectors is a reminder that investors still believe we’re late in the cycle.

Don’t fight the Fed. Markets could continue performing well now interest rates are headed lower.

However, do play it a little safer than usual, watch economic indicators closely and remain open-minded about adjusting your strategy.

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