Market Strength as Rate Cuts Loom

The markets closed quite strong last week and were approaching all-time highs again for the S&P 500. The most recent Presidential debate shifted the odds markets, as Harris became a 55-45 favorite on the betting site PredictIt and a very slight favorite on Polymarket. It is positive for the risk markets which did not pull back with Harris gaining strength.

From a macroeconomic standpoint, last week’s inflation data offered comfort yet again. Bureau of Labor Statistics (BLS) housing data continues to be a significant upward skew to overall inflation figures. Using more real time data for shelter, we see headline inflation running just 1.2%, which is half the officially reported figure of 2.5%. Core inflation is also just half the official statistics at 1.6%. Certainly, the focus from the Federal Reserve (Fed) has rightfully turned to the employment side of their mandate.

Regarding the Fed's anticipated actions, the market expects a steady series of rate cuts. My read of the Fed Funds Futures market shows the expectation of seven rate cuts in a row between now and next June—one cut at each meeting when you factor in the risk premium and hedging features these futures contracts possess (which actually show more than nine 25 basis point (bp) cuts).

This would ideally align with the long-run equilibrium real funds rate that I have been advocating between 3.5% to 4%. I would like the Fed to move quicker, as you all know, but so far, the market is comfortable with the Fed Funds Rate reaching the three handle by the middle of next year. I anticipate them to start with a 25 bp cut this week unless the retail sales report is unusually weak.

We’ve received some questions about why the inverted yield curve has not brought on a recession like past inversions. Typically, the Fed is reacting to a jump in inflation expectations and rapid increases to the Fed Funds Rate to bring down these expectations. Those past hiking cycles that caused the inversions typically caused the recession.

The yield curve inversion we're observing now is influenced heavily by unique post-pandemic economic factors. Longer-term inflation expectations never became unanchored through the pandemic. This is a major reason a soft landing is a high probability.

On a broader scale, the equity markets have remained resilient, particularly favoring value and dividend-paying stocks this quarter. This inclination may gain momentum as the Fed begins to implement rate cuts, enhancing the attractiveness of these equities relative to bonds.

And for the market as a whole, the 10-year U.S. inflation adjusted bond yield reached 1.6% on Friday. With the S&P 500 selling at nearly 20 times earnings and a 5% earnings yield, I see the equity premium as being approximately 3.4%—which is very close to the long-term data in my book Stocks for the Long Run. Both stocks and bonds are expensive compared to historical levels—but each by about the same amount—and still support the case for stocks.