In the world of investing, questioning conventional wisdom is often the key to staying ahead. That’s precisely what Malcolm Polley, CFA, Chief Market Strategist for Stratos Investment Management, does in this thought-provoking piece. With over three decades of experience navigating volatile markets since his start on Black Monday in 1987, Malcolm offers unique insights into today’s economic landscape, challenging the mainstream narrative around the Federal Reserve's policies.
In this article, Malcolm poses a critical question: What if the Fed doesn’t do as much? He examines market expectations for significant rate cuts and raises the possibility that the Federal Open Market Committee (FOMC) might take a more measured approach. Drawing on key economic indicators like the inverted yield curve and the SAHM Rule, Malcolm questions the reliability of traditional signals in predicting a recession. He suggests that the economy’s resilience, with steady GDP growth, could mean that fears of a looming recession might be overstated.
Malcolm’s analysis goes further, exploring the potential consequences if the Fed opts for smaller-than-anticipated rate cuts. He highlights the impact this could have on bond returns, longer-duration assets, and key sectors like real estate and equities. By challenging the prevailing sentiment, Malcolm encourages readers to consider a range of outcomes and prepare for surprises in the financial landscape.
We invite you to dive into this insightful commentary and benefit from Malcolm’s extensive experience and forward-thinking perspective. His analysis provides valuable context and challenges assumptions that could shape the way we think about the markets today.
In the most recent Federal Open Market Committee’s Summary of Economic Projections forecast of the Fed Funds rate for the balance of this year and next year, the FOMC is expected to do two additional 25bp cuts to its Fed Funds rate to an effective rate of 4.4% (this is a rounding in the expected range of 4.25% - 4.5%). FOMC projections and the market also expects an additional 100bp in cuts in 2025 to an effective policy rate of 3.4%. This got us thinking… If the market expects the Fed to cut a total of 1.5%, what if we don’t get or need that much?
It should go without saying that the Fed changed its monetary policy using the Fed Funds rate in order to forestall unwanted changes in economic activity. Essentially, the Fed uses its monetary policy tools (its Fed Funds and Discount Rates) to cool an overheating economy by increasing its policy rates or boost economic output by cutting those same rates. Ultimately, the Fed tries to walk the tightrope of its dual mandate of stable prices and full employment, keeping the economy running neither too hot nor too cold.
Having taken its Fed Funds rate from (effectively) zero in the spring of 2022 to a cycle high of 5.33% in August of 2023, the FOMC began reversing course in September with a 50bp cut. While we believe that some investors had been concerned that the Fed had overplayed its hand and kept monetary policy tighter than it should have in trying to get inflation down to its stated 2% target, ultimately the FOMC decided it was prudent to shift its focus away from inflation to employment and cut rates. Which begs the question,
“Is/was the economy in that much danger of slipping into recession?”
There have been signs that the economy was in danger of and potentially could even be in a recession. The Index of Leading Economic Indicators (LEI – an index of 10 economic components whose change tend to precede changes in the overall economy, created by The Conference Board) have been flashing a warning since the summer of 2022, and while it has been below 100 (the level consistent with an expanding economy) it bottomed in January 2023 and has been rising steadily since.
Chart 1: Source- Federal Reserve Bank of St. Louis FRED database
The yield curve has been inverted (long-term interest rates lower than short-term interest rates) since 2022 (since July ’22 when comparing 10-year and 2-year treasury rates, since October ’22 when comparing 10-year and 3-month treasury rates and since November ’22 when comparing 10-year and Fed Funds rates) with no recession. (An inverted yield curve often indicates that a recession is near.) So, what gives?
Chart 2: Source- Federal Reserve Bank of St. Louis FRED database
Even the (recently) reliable SAHM Rule, which has correctly indicated a recession going back to the early 1960s, has come up short. (The SAHM Rule indicates the potential for recession when the three-month moving average of the national unemployment rate rises by 0.50% or more relative to the minimum of the three-month averages from the previous 12-months.)
Chart 3: Source- Federal Reserve Bank of St. Louis FRED database
In fact, we believe that it is the SAHM Rule data that gave the FOMC pause and caused them to begin the process of reducing rates. Which gets us back to the question asked at the heading of this section: Are we headed for a recession or not?
We have been of the belief (opinion) that though the economy has likely been experiencing rolling recessions for a while now, the broader economy would not completely roll over. Additionally, we have believed that much of the strangeness of the economic readings the past couple of years could likely be explained by the unusual nature, severity and fiscal (monetary) response to the COVID-induced recession. Extreme events call for extreme (unusual) responses.
In Bill Clinton’s 1992 presidential campaign, one of his strategists (James Carvill) coined the term, “It’s the economy stupid’” as one of three messages for the campaign’s workers to focus on in their (ultimately) successful attempt to unseat, then president, George H. W. Bush. He was (is) right. It is the economy… In fact, if we look at Real GDP, we will note that it really doesn’t look as if the domestic economy is in any real danger. After bottoming (most recently) with 1.3% growth in the fourth quarter of 2022, GDP growth has resumed a “relatively” reasonable growth rate of between 2.8 – 3.2%.
Does this look like an economy in danger of falling into recession? We don’t think so. In fact, it really looks to us as if the COVID-induced recession (and snap-back recovery) was the real anomaly and that the economy has simply resumed the growth path in place since the end of the Great Recession in 2009.
Chart 4: Source- Federal Reserve Bank of St. Louis FRED database
Which, again, begs the question: Does the Fed really need to cut rates much in order to stave off a recession? In our view, the answer is no.
So… what happens if the market is looking for (currently) at least 150bp of additional rate cuts through the end of 2025, and we don’t actually need or get them? That could create some surprises. Not the least of which is that it could (potentially) upend expectations for bond returns.
Below is a chart that shows the current Treasury Yield Curve and what we think the market believes could happen to the yield curve if 1) the Fed continues to cut rates as expected and 2) the yield curve normalizes:
Chart 5: Source- Factset
Since interest rates and bond prices move in opposite directions, the biggest impact to a lower Fed Funds rate would likely be felt by those invested at the shorter end of the yield curve. This is because the value of existing short(er) term bonds should rise as rates fall. Longer term bonds would likely not be much impacted as (at least according to the chart above) a decline in short rates shouldn’t have much of an impact since rates at the longer end of the curve shouldn’t move much.
But… what would happen to bond prices if short(er) term interest rates don’t decline that much because the Fed decides that the dangers of a faltering economy aren’t as large as they thought or… inflation decides to make a comeback? Let’s take a look.
Regardless of what happens to the Fed Funds rate, we continue to believe that the yield curve normalizes. (A “normal” yield curve is one that is upward sloping. In other words, longer maturity bonds have higher yields than shorter maturity bonds.) If the curve normalizes and short-term rates don’t fall as far as the markets (or the FOMC “dot-plot”) seem to think, then bond investors could be in for a far different ride.
The chart below shows the current yield curve and an alternative yield curve if Fed Funds only goes to 4% and that the spreads between Fed Funds, the 3-Month T-bill and the 2 Yr Note relative to 10-year Treasury bonds reverts to their long-term “norms”, assuming an upward sloping yield curve. (These “norms” were created by determining the average spread during “generally positive spread” periods from the beginning of available data according to the Federal Reserve Bank of St Louis FRED database.)
Chart 6: Source- Factset and the Federal Reserve Bank of St. Louis Fred Database
Much like the earlier chart that showed what a yield curve might look like if Fed Funds fell to the expected 3.38%, the shorter rates move down providing better returns for shorter rates. However, while short rates certainly move down, the only short bonds positively impacted by falling rates are from 1 year and less, whereas the longer-term bonds all rise in price creating potentially negative returns. The chart below shows the potential performance impact of the yield curves in both Charts 5 and 6. (Potential returns are provided only for maturities from 1 Yr – 30 Yrs, where durations have been pulled from FactSet available data.)
Maturity |
Duration |
Chart 5 Return |
Chart 6 Return |
| 1Y | 0.96 | 4.56 | 4.22 |
| 2Y | 1.87 | 4.15 | 3.40 |
| 3Y | 2.81 | 3.86 | 2.21 |
| 5Y | 4.50 | 3.60 | 0.00 |
| 7Y | 6.07 | 3.53 | -2.55 |
| 10Y | 8.04 | 4.08 | -6.26 |
| 20Y | 13.19 | 4.45 | -8.11 |
| 30Y | 16.53 | 4.40 | -13.04 |
As you can see from the chart above, if the Fed does as expected and the yield curve normalizes, then returns along the yield curve are reasonably positive. However, if the Fed doesn’t cut as much as expected and the yield curve normalizes, then returns for maturities of five years and more range from zero to double-digit negative.
Bonds might also not be the only asset class negatively impacted by rising long(er) rates. We believe that all longer duration assets should be similarly impacted. Equities, whose discount rate tends to be benchmarked against the 10-year treasury, could be negatively impacted. This would be true even with rising earnings as those earnings would be discounted at a higher rate, driving down value. Real Estate could be negatively impacted as cap rates (which are used to value commercial real estate cash flows) may rise also driving down values. Anything which is valued using discounted cash flows could see values come under pressure as the discount rate used rises.
In an environment where it appears the market assumes the need for lower rates to stave off recession, it might be prudent to understand what could happen if the Fed realizes that a recession might not be its biggest risk and either delays (some) future rate cuts or decides that the level of cuts needed isn’t as large as they first thought…
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