George Soros famously made billions by discounting what is fully priced in and betting on the unexpected (often with long odds).
The probability of an Federal Open Market Committee (FOMC) rate cut this week is certain; the debate is 25 bps or 50 bps. Our bet is 25 bps – as of writing 11 a.m. on Monday, Sept. 16, a 65 per cent chance of 50 bps.
Over the next year, we already have 250 bps of rate cuts in the short-term interest rate market (STIR) priced in. Something different will likely play out.
In order for the Dot Plot (summary of economic projections) to move to what the market is pricing in, the median FOMC member must see a hard landing coming.
We do not believe that is the current mentality of the committee based on recent statements. So we expect them to set the path of rate cuts on a slower trajectory. To be sure, Powell will very likely leave that door wide open in a data dependency way.
For investors, it’s time to reduce exposure to rate-sensitive names that have rallied in recent weeks/months to price in the beginning of the rate-cut cycle. We sold some utilities and bond duration last week in many of our portfolios.
Andy Constan of Damped Springs Advisors, a U.S.-based hedge fund consulting firm, and likely many macro-focused hedge funds, consider four possible outcomes from the combination of rate cuts plus Powell spin at the press conference.
A notorious dove, it will be hard to see him give a hawkish message unless he wants to contain asset prices.
Constan points out that the Taylor rule is doing all the heavy lifting. Using published median economic consensus estimates of unemployment rate, core personal consumption expenditures and gross domestic product for 2024 and 2025 (and assuming no change in longer-term neutral rates), the Taylor rule suggests 75 to 100 bp of cuts for 2024 and 125 to 150 bp of cuts through December 2025.
Markets are far ahead of both of those paths so expect something different to happen. When markets are set up for an extreme outcome, there is always an opportunity lurking.
Constan says the FOMC Summary of Economic Projections (SEP) needs to have GDP down to 2 per cent, the unemployment rate to 4.4 per cent and the inflation target to 2.5 per cent for 2024 and 1.6 per cent, 4.4 per cent and 2 per cent for end of 2025 for the 250 bps of rate cuts priced in to be plausible.
It’s not impossible, but if they take growth down that much and move the unemployment rate up, the message the market could interpret is that they are fearing a recession. We do not expect they want to send that message.
For investors, no need to panic. But when policy changes, there are always opportunities to rebalance portfolios.
Constan believes cash will likely outperform bonds and stocks in the coming months until both asset classes better reflect the more likely path of growth and inflation. Caution remains the message with both stocks and bonds pricing in a near-perfect outcome at the end of the business cycle.
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