Tag Archive for: fed

Navigating the Rate Cut: A Guide for Advisors

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Introduction

The ongoing Federal Reserve cycle has sparked intense debate regarding its resemblance to the 2007 and 1998 financial crises. While a definitive answer remains elusive, the devil is indeed in the details. The current economic landscape shares similarities with both 2007 and 1998, but the specific outcomes remain uncertain. The stark contrast between the record-breaking stock market of 1998 and the near-50% decline in 2007 underscores the importance of discerning the underlying factors driving each crisis. However, one consistent element across these periods is the rise in volatility following Federal Reserve rate cuts.

Source: Bloomberg

Historical Context and Current Trends

A recurring pattern emerges in financial markets: a steepening yield curve often coincides with increased volatility. This phenomenon is evident in both 2007 and 1998, as well as other periods of economic downturn.

Source: CME Group

  • The Volatility Cycle: The yield curve’s movements often correlate with cyclical volatility patterns. A flat yield curve, typically associated with the end of an economic expansion and higher interest rates, often precedes a period of lower volatility. When the Federal Reserve cuts rates, steepening the yield curve, volatility tends to rise. This peak in volatility often coincides with the steepest point of the yield curve.
  • The 2007 and 1998 Comparison: While both 2007 and 1998 featured a steepening yield curve and rising volatility, the underlying causes differed. In 1998, a volatility shock triggered by the Russian debt crisis prompted the Fed to lower rates. Conversely, in 2007, the Fed’s rate cuts were a response to a deteriorating labor market.

 

Volatility and the yield curve, often described as mean-reverting, exhibit a similar cyclical pattern of highs and lows.

The Current Landscape

The Federal Reserve’s decision to lower interest rates in 2024, amidst a backdrop of declining inflation and market volatility, raises questions about the similarities and differences to past crises. While the exact trajectory remains uncertain, the rising yield curve and increasing volatility suggest a potential parallel to the many times in history the Yield Curve got steeper.

The visualization below demonstrates the historical pattern: As the yield curve (in black) rises, volatility (in orange) follows suit.

Source: Bloomberg

Conclusion

As the financial landscape continues to evolve, understanding the historical context and current trends is essential for making informed investment decisions. By recognizing the cyclical nature of volatility and leveraging specialized strategies, investors can mitigate risks and protect their portfolios from market downturns.

 

My 50-Cents – Fed Analysis from Leland Abrams of Wynkoop, LLC

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The Federal Reserve Board cut their benchmark rate this week by 50 bps to a new range of 4.75% – 5.00%.  They indicated this is the start of a rate cutting process and further cuts were coming, likely another 50 bps by year end.  The market had been pricing in an approximate 65% chance of this happening the day of the decision.  We boldly prognosticated this larger than usual rate cut more than two months ago when the market was not even fully pricing in a chance of a 25 bps cut at the September FOMC meeting.

 

Anyone who has observed the material weakening in the labor market coupled with quickly dropping inflation (and deflation in economically sensitive areas) in addition to the very weak observations in the Fed’s Beige Book should not have been surprised by the size of this first rate cut.  Fed Chairman Jay Powell brought up the Beige Book without being prompted when defending his rate cut during the press conference on Wednesday.  The Beige Book, a qualitative summary of business and economic activity by region, did not paint a good picture.  According to its findings, more than half of the Federal Reserve Districts are already in a recession (declining economic activity) and another quarter are experiencing stagnant growth.  This report does not jive with the Bureau of Labor Statistics’ GDP reports.  We believe the Beige Book offers a better, real-time, glimpse into what is happening on the ground with respect to the economy.  This clearly spooked Jay Powell.

 

We have written ad nauseum about inflation coming down and likely being lower than the reports indicate.  For example, if the U.S. used the European calculation for inflation, we would see a YoY number in the high 1%s, below the Fed target of 2%.  Economically sensitive areas are experiencing outright and accelerating deflation.  While GDP measures aggregate demand of the economy, one must look at the supply side to see where prices are going.  Aggregate supply has outstripped aggregate demand, which puts DOWNWARD pressure on prices.  Also, the commodity complex has been performing terribly despite a weaker dollar (weak dollar usually makes commodities rally).  We see little to no reason to be concerned about inflation reigniting.

 

The bond market was mostly ahead of the Fed’s cut and now the two are relatively in sync with each other (bond futures pricing and Fed dot plot).  We noted previously that the longer end of the curve could become stuck and we favored the front end of the curve, which still has significant room to drop.  The initial reaction to the Fed 50 bp cut was actually to see bonds selling off (an example of buy the rumor, sell the fact).  If we study the analogs of 2000/2001 and particularly 2007 (the 2-year note behavior is almost identical), we see some correction selling off (yields moving slightly higher) in the short term, only to resume a significant bull-steepening rally of the rate curve in the coming months.

 

We are not in the soft-landing camp.  We think the Fed was and still is behind the curve and believe it is unlikely they can arrest the deterioration in the jobs market and hence economic activity.  If history rhymes, the recession we’ve all been waiting for (and many who have given up on) may have just begun.