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Weekly Market Analysis - US Federal Reserve Easing – Look Beyond the Obvious
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Powell at Jackson Hole: Focus on Inflation and Employment
Near a turning point for US monetary policy, Fed Chair Jerome Powell will address the annual Kansas City Fed Jackson Hole symposium late this coming week. The Fed has kept the upper end of its policy rate at 5.5% for more than a year. We believe Powell will focus on the need for forward-looking policy to adapt to slowing US inflation and employment growth to avoid an unneeded hard landing.Near a turning point for US monetary policy, Fed Chair Jerome Powell will address the annual Kansas City Fed Jackson Hole symposium late this coming week. The Fed has kept the upper end of its policy rate at 5.5% for more than a year. We believe Powell will focus on the need for forward-looking policy to adapt to slowing US inflation and employment growth to avoid an unneeded hard landing.
Fed Easing is Anticipated
One shouldn’t think of Fed easing as a “positive catalyst” when action is heavily anticipated. In the present case, we also don’t see the Fed’s action as “too late.”
Still Time for the Fed to Act
Fed rate cuts of about 200 basis points by end 2025 are clearly priced into US Treasury yields. A failure of the committee to cut would result in an effective tightening of monetary policy. The Fed has “endorsed” market pricing by acting in line with expectations in 79% of all cases in the past 34 years. In the event of easing steps, the Fed has eased more than markets expected in an additional 14% of cases. There’s still time for markets and the Fed to calibrate the initial pace of rate cuts before the FOMC meets September 17-18.
Summary
Later this week, Fed Chair Powell will give us his views on "Reassessing the Effectiveness and Transmission of Monetary Policy" – the theme of the annual Kansas City Fed Jackson Hole Symposium. Over many years, the Jackson Hole speech has been a market mover. Assessing how strong the impact of Fed policy adjustments is embedded in various asset prices – how good or bad markets are at gauging the future path of various parts of the economy – presents both opportunity and risk for the world’s investors.
How US banks will be regulated will in part depend on the US election outcome in November. Irrespective of this, Fed easing is likely to ignite recovery in some key drivers of housing finance with positive spillovers to capital markets activity. US banks have underperformed other housing-sensitive equities such as homebuilders. With US bank dividend yields at crisis level premiums over the broad US stock market, we wouldn’t be surprised if banks and residential REITs outperform other shares in the coming year.
Portfolio considerations
- The yen’s sudden, massive surge (see last week’s CIO Bulletin) shows that not all global markets are “efficiently” priced, even for highly anticipated US rate cuts. This shows investors and risk managers need to look beyond the obvious to assess the future impact of rate cuts.
- In the US, a very sharp tightening cycle has managed to stifle the residential real estate market despite fairly widespread housing shortages. Fed easing is likely to significantly boost housing turnover and strengthen closely-related economic activity over the coming year. For investors, the positive impact doesn’t appear priced into US bank equities in particular.
Source: Bloomberg as of August 14, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Powell at Jackson Hole: Focus on Inflation and Employment
Just consider, in the past two years as the Fed tightened monetary policy, the following happened:
- The US stock market fell 25.0% from January through October 2022
- The US Treasury market return was -19.7% from July 2020-October 2022
- US banks tightened lending standards for 9 consecutive quarters through 2Q 2024
- US real residential investment fell 20.5% in the two years ending 1Q 2023
- US home resales fell 40.2% from December 2020 through June 2024
- US manufacturing production fell 2.0% in the year through January 2024
- US goods imports fell 12.7% in the year through March 2023
What does this list mean? The year 2022 bore all the scars of a recession in terms of tightening financial conditions. Interest rate sensitive industries like housing saw declines comparable to significant recessions of the past other than 2008/2009. US trade and manufacturing posted contractions consistent with a mild recession even though consumer demand never declined. What didn’t fall was US employment.
US services hiring is in a slowdown. This should persist, but it is a normal outcome after a short, severe shock and fast recovery. In contrast, we see the potential for a relatively rapid strengthening of housing as the Fed normalizes policy rates.
Fed Easing is Anticipated
The Fed has frequently eased in reaction to an oncoming recession. For that reason, investors should be careful in assuming a lower policy rate will boost financial markets. However, our view in the present case is that significant parts of the US and world economy have already, in fact, been held back by tight US monetary policy.
If monetary easing boosts US housing and other rate-sensitive cyclical industries, it would keep the post 2020 economic recovery intact. It will continue to stump “simple rule followers” (please see our Top Five Questions We’re Getting CIO Bulletin).
Still Time for the Fed to Act
US banks recently sold off as recession fears pervaded markets. While the hit to their performance in early August was not as severe as the drop in highly-valued US tech shares, US banks have trailed behind the S&P 500 in the past year.
The underperformance of US banks has been very long lasting, dating to the Global Financial Crisis. Banks also saw a distinct drop in their relative performance in early 2023, as Silicon Valley Bank’s failure showed some banks were unprepared to absorb mark-to-market losses on depreciated US Treasury securities following the Fed’s policy tightening. US Treasury yields have now fallen, relieving this fear. However, Fed easing cycles have often been associated with negative credit events. Pockets of weakness for smaller lenders in commercial office lending are notable, but much smaller than housing credit.
How US banks will be regulated will in part depend on the US election outcome in November. Irrespective of this, Fed easing is likely to ignite recovery in some key drivers of housing finance with positive spillovers to capital markets activity. US banks have underperformed other housing-sensitive equities such as homebuilders. With US bank dividend yields at crisis level premiums over the broad US stock market, we wouldn’t be surprised if banks and residential REITs outperform other shares in the coming year.
