Expect A .25% Cut And A Cautious Fed Statement, Buy The Dip

Expect A .25% Cut, and a Cautious Fed Statement, Buy The Dip

Market participants have been traveling a well-worn path for 2 years. Every time there was some discussion about cutting interest rates, the speculative chatter would swell the possibilities to outsized proportions. Only later to be disappointed when lanced by reality. The reality in this case is that demand could reignite inflation. Talk of at least 100 basis points from now until the end of the year, and then perhaps 100 BPs rapidly in 2025 is just too far. Do we really think Powell will risk unleashing a tremendous amount of money supply in such a short period? The last thing Powell wants is to reignite inflation.

How will lowering the Fed Funds Rate raise the money supply?

This is likely your first question, it would be mine. The lower the FFR, the lower the other rates of bonds of longer maturity become. Already the 10-Y has a 3-handle on it, I suspect that once the Fed cuts rates the 10-Y will firm up a bit, especially if, as I believe, the Fed cuts by .25%. However, if the Fed cuts by .50% I think that will cause a rush into the long end because the Fed is signaling aggressive cutting. That will further pressure mortgage rates, this week I saw the 30-year fixed rate as low as 6.15%. It would be very plausible to see a 5-handle on rates with an aggressive Fed. That in turn would unleash a flood of Refinancing, putting a lot of cash in the hands of consumers. Also, with the lower FFR and a normalized rate curve, we could see more lending of regional banks who have been starving for better NIM – Net Interest Margin. More bank lending increases the money supply as well. The simple definition of inflation is too much money demanding not enough goods. More money supply, more inflation.

Just a reminder that the S&P 500 is fully priced right now, it’s vulnerable to bad news

The S&P 500 gained 4% this week, reversing the bad performance at the start of the month. The 500 stock index closed at 5626, just 40 points shy of the all-time high. Furthermore, the current average PE is 27.80, which is quite fully valued. Of course, the Super 6, or Magnificent 7, or Super 8, however you want to organize the biggest market cap growth stocks are pulling up the current PE. I agree, but the biggest, best growth stocks have always pulled up the average PE. Valuation is a very poor timing mechanism, and I would only cite it because we are coming to a very important new piece of data. There are a lot of unknowns going into this decision, will a 25% rate cut disappoint the market? If Powell gives a buoyant projection of rate cuts, ones that won’t be interrupted by new macro data that show a jump in inflation potential? Then great, I think the stock market does fly, and long rates drop even further. If Powell cuts by 50% but gives a more dour forward guidance, then I think the market sells off. Though I expect a .25%, it is how Powell presents the cut that is really the important event on the 18th.

I thought the consensus was for a .25% cut, but now .50% is being bandied about

It seemed a settled notion that the Fed was going to cut .25% given the fairly strong economic numbers of the last week or so. In the last half of the week, there was more chatter that there would be a .50% cut. There is a very good chance that a .50% cut could roil the market, with the question of what does the Fed know that we don’t? Therefore, if there is a .50% cut, Powell would like to explain away an aggressive cutting cycle and remain conservative. Again, I believe that no matter what, Powell should stress that the cutting will be very gradual. The rationale for cutting is that the “real rate” — the current interest rate minus the rate of inflation, is too high. I maintain that no one really knows what the “real interest rate” is. Otherwise, we’d have been in recession long ago. Don’t let us forget the countless wise men and women who made the pronouncement that a recession was around the corner. Yet, a recession did not come. Though, there were many excuses, like the free money that was handed out. Sure, that helped, but that money has long been spent. The real reason the economy did not falter was that the demand for jobs was enormous. Also, we had a huge influx of workers that helped grow the economy even with higher interest rates. Now the higher rates have finally gained traction and the economy is slowing somewhat.

Be careful what you wish for

The very thing that is spooking the market at times is what we were hoping would happen. Fewer jobs, and fewer job openings, and it is a tad harder to get a new job. Also, a very good and unexpected thing is higher productivity. High productivity might also temporarily lower demand for workers, so it might not even be the higher rates as the sole reason for greater job scarcity. When I say job scarcity, there are still more job openings than there are jobs, just not as many. According to the Federal Reserve Data – FRED, there are 1.2 openings per available worker. So while we are witnessing an unemployment percentage that is creeping up, there are still enough jobs out there. That doesn’t mean it was as easy as before. It also means that employers can be a lot more demanding about education and experience. I feel sorry for college graduates who majored in Anthropology or other liberal arts degrees. They may end up getting some training in AI development or some such skills to get a job.

I don’t believe Powell is that concerned about the unemployment percentage at 4.3 or even if it rises to 4.5% these are still great unemployment numbers. The concept of full employment used to be at 6% in the US. What Powell doesn’t want to see is that by June of 2025, inflation starts to go up with all this additional money that has been put in the pockets of the home-owning middle class. These are the ones that are still spending on experiences, and dining out. Now with lower mortgage payments after refinancing or some getting HELOCs – Home Equity Line of Credit to spend on new goodies. Also, even without an increased money supply than we already have, The Atlanta Fed GDPNow estimate is 2.5%. That is in no way signaling a recession, so why go .50% and throw caution to the wind with a dovish-cutting regime? It makes absolutely no sense.

I have been harping on the notion of a sell-off for a few weeks, for the latter half of September, and here we are. So, does that mean you sell everything on Monday morning? At this point, if you wanted to be cautious you’d have some cash ready in your trading account, and long-time readers should by now remember that I have been saving up my investment allocation for this Fall hoping to collect some stocks on sale. If I am wrong and Powell does come in like a dove, then maybe he truly knows something that we don’t know. Warren Buffett has been selling a lot of stock in Apple (AAPL), and Bank of America (BAC). Ajit Jain, Berkshire Hathaway’s top man, has sold half of his Berkshire Hathaway (BRK.A) stock. I usually don’t make a thing about stock selling; it just seems odd timing. Especially since Ajit is one of the people named to take over when Mr. Buffett retires. Anyway, it’s easy to be a bearish writer, but not that easy to be a bearish investor or trader, especially a trader. If we do end up rallying, then there is the November presidential election that normally has some kind of October surprise, though Biden leaving the race might have been October come early. If I am correct, Powell doesn’t go completely into the dovish camp and confirms 100 BPs of cuts. Then he has to take a measured approach to cutting. The economy is still growing nicely, but it makes sense to loosen things up because inflation is under control, so .25% now and a few .25% cuts in the future. I do expect a sell-off with that news, but it could be mild. The real selling could come on any news that references a slowing economy, even though it is the only way the Fed can fight inflation, keeping rates on the high side even as they slowly lower them.

Even though a .25% cut should cause just a small sell-off, it could be sharper

On the other hand, a fully valued market selling-off may result in losing all the gains of last week. A 4% retreat in the offing might cause some selling in the next 3 trading days as well.

What to do?

The easy answer is to maintain some hedges going into the next few days. I added to my hedges on Friday, but I also sold some positions to have cash ready, to pick up some names that would likely be used as a source of funds. If you guess the technology stocks, you would be correct. The Tech Titans outperformed the market to the upside last week. In my opinion, I want to note that big-cap tech was once seen as a safe haven in times of instability, most of this year. We haven’t seen that lately because in a lower interest rate environment, other stocks can go up as well. So I expect these high growth big cap names to give up their gains. NVIDIA (NVDA) gained about 20 points last week, if it gives those 20 points back up, I would be inclined to pick some NVDA. I have seen an interesting pattern with Micron (MU) though it isn’t a big-cap tech name, it trades with NVDA. Bank Paribas gave MU a double downgrade, the stock fell in the morning on Thursday and I got in for a trade, closing it on Friday up 25%. If the market sells off as I expect, I might trade it again. I think Alphabet (GOOGL) put in a bottom this week with all the legal concerns, so if GOOGL falls back to that bottom of this week. I think it could be a nice trade.

Investing

As far as investing is concerned, I want to share a direction rather than specifics. Lowering rates is going to be a real trend for the next 18 months. Think about what businesses would benefit from lower rates. I pointed to a Refi trend, so companies that originate mortgages should do well. Select banks should do well as the yield curve normalizes; they can make small business loans and mortgages since Money Market Funds will be going lower and their margins will rise. Insurance companies have already been doing great, with borrowing costs lower they could leverage more returns. Cyclical industries should be doing a lot better, and money to spend on consumer services should continue to do well. I am sharing an interest rate strategy paper with my investment group. It’s hard to focus just purely on the stocks that will appreciate because business is better at lower rates. The truth is, all businesses do better when credit is at a more reasonable level.

My current trades

Right now, I am hedging using Puts on the 3X S&P 500 (SPXL) and the 3X Nasdaq-100 (TQQQ).

I am long Rocket Companies (RKT) for the Refi concept, I have an expiration all the way out to March, so I can wait. I am also long Rubrik (RBRK), their IPO lock-up expired this past week and I think it should have a nice bounce back. I have that expiration out to April, so I can wait for it to reach back to old highs. Finally, I am Long Viking Therapeutics (VKTX) based on the progress of their GLP-1 including a pill version. I think one of the big pharma names will wise up and pay up for it. I have a long-term investment in it. I made my first purchase for $17 a share, and my average cost basis is $30. The current market cap is about $7.5B. I think it’s worth 3 times that to the right buyer. Even as it continues progressing, I think the stock should continue to move back to its old high of 99. Of course, this is just me thinking out loud.

Best of luck to everyone. If I am wrong and the market rallies after the cut, please be careful anyway, hold some cash. As you trade, set aside your winnings to cash. September is still September.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.