It's Time for the Fed to Cut

Never before in my history studying the Federal Reserve (Fed) has the Fed’s policy come into question immediately following the Fed decision. Jerome Powell was asked at his press conference whether a 50-basis point (bp) rate cut was possible at the next meeting, and he was steadfast that this bold action was not currently contemplated. It should be—and it should be done without delay.

I am now calling for more. The Fed should make an immediate 75 bp inter-meeting cut and follow that up with a 75 bp cut at the September meeting. The reasons are simple. The Fed says the long-term Fed Funds rate should be 2.8%. There are two variables that they look at to set the funds rate: unemployment and inflation. We have already blown beyond the Fed’s 4.2% long-term unemployment rate, and we are within 50 bps of the Fed’s inflation target. Why hasn’t the Fed lowered its very restricted 5.33% Funds rate at all! The funds rate should be 4% or less; at least.

The labor market reports were well below expectations and revealed a surprising uptick in the unemployment rate to 4.3%. There was also a one-tenth tick down in the hours worked. With 160 million workers, a 0.3% drop in hours worked is equivalent to over 450,000 less jobs—which more than wipes out the jobs gained on the month four times over. Clearly the labor market is softening and that was also reflected in the weekly jobless claims surpassing the 240,000 sweet spot that I highlighted as the upper end of a range indicative of a healthy economic environment.

Additionally, the geopolitical landscape continues to inject volatility into the markets. The situation in the Middle East remains a critical factor of uncertainty that could influence oil prices and broader market sentiment. But for now, the fall in commodity prices should give the Fed further confidence that inflation is receding.

Amidst all the market recalibrations, an important shift in July was the rotation from growth stocks to dividend-paying value stocks. As concerns about an economic slowdown permeate, the allure of high-growth tech stocks has diminished, paving the way for a resurgence in interest towards sectors that traditionally offer steady dividends. Friday bond yields dropped, and the 10-year TIPS yields reached 1.6%.

As the Fed begins to more aggressively bring down rates, dividend-paying value stocks become the prime beneficiary and are relatively much more attractive—as one can get higher yields that also offer real growth on top of inflation over the longer run. Bonds finally showed hedging characteristics again as fears of a recession picked back up. A sharply rising correlation between stocks and bonds during the inflation scare is one factor that has pushed up yields—so a return to a regime of bonds providing diversification could lead to even further moves down in long-term rates and further support for the higher-dividend yielding sectors.

Volatility has not surprisingly finally returned to the market. This equity risk is what creates a premium long-term return and a correction of 5-10% from the highs I generally view as healthy. I would be more worried had the market continued to surge higher with no correction and created more bubble-like conditions. The equity premium and forward-looking prospects for stocks vs. bonds improved last week and that is a good thing for long-term stock allocators. In the short run, if the Fed does not indicate that it will react soon, the outlook is very unsettled.