With stock markets plunging around the world, traders are talking up the prospect of an emergency interest-rate cut from the Federal Reserve after the US central bank passed up the opportunity to ease policy last week. Not only is this highly unlikely, it would be counterproductive.
This equity downdraft is fundamentally a market positioning unwind, not a response to an economic shock. Swathes of investors have gotten over their skis on over-leveraged trades; from borrowing cheaply in low-interest rate Japanese yen to chasing the bubble in technology stocks, especially anything AI related. It's their Icarus moment.
There’s nothing broken in the US economy, so there's no justification for the monetary authorities to step in and mitigate losses for over-extended equity holders. The fabled "Fed put" is a break-glass lever only to be used in event of a proper emergency — and we're not there yet.
The risks of a US recession have risen, but a contraction is far from being the base case scenario. The Atlanta Fed gross domestic product nowcast is anticipating growth of more than 2% in the third quarter, a repeat of impressive second-quarter strength. Friday’s July employment report came in weaker than economists anticipated, but Hurricane Beryl effects make it hard to discern any worrisome trend, as opposed to simply a single month of less robust payroll gains. The latest corporate earnings season is also pretty decent across the board, albeit with a handful of exceptions.
What’s probably a more sustainable trend, though, is lower government borrowing costs, after fixed-income investors have suffered a couple of disastrous years of rising bond yields. The US Treasury 10-year yield has fallen 100 basis points to around 3.75% over the past three months, with half of that decline coming in the last eight trading sessions. Nonetheless, the two- to 10-year yield curve remains inverted by 26 basis points — but that’s not a flashing recession alert. Bonds are reasserting their place in the investment mix versus once-omnipotent equities — a gradual evolution as the economic landscape becomes more mixed, and restrictive borrowing costs to crush inflation become evidently less necessary.
Emergency rate cuts do happen; but they’re relatively rare, and are only employed when the economy is facing a sudden seizure. The last pair were in March 2020 in response to the pandemic, when interest rates were lowered 150 basis points to zero, where the Fed Funds rate stayed for two years. Prior to that, there were several during the global financial crisis. There were a couple of intra-meeting 50 basis-point cuts after the 2001 tech bubble burst, and a subsequent move after the Sept. 11, 2001, atrocities, but the Fed has learned hard lessons from the perception that it protects investors from their own irrational exuberance.
The Fed's next meeting is on Sept. 18, and a 50 basis-point reduction is nearly fully priced in by the futures market. Although Chair Jerome Powell played down the prospect of an outsized initial rate cut at the July 31 press conference, that view may no longer hold. The Fed is aware it has been keeping official rates restrictive for possibly too long. But it doesn't need to overreact, especially in an election year. Easing cycles often start with a half-point cut, and this time such a move may be justified — but at the right time and place, at a scheduled meeting rather than as an emergency response to an overdue correction in the stock market.
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