US Strategy Weekly: The First Cut

It is finally here. The September FOMC meeting and the long-awaited rate cut by the Federal Reserve. The last rate cut occurred during the pandemic in March 2020. In our view, we will get a 25 basis point cut, but in reality, there is little difference between 25 or 50 basis points, particularly since it is likely to be the first in a series. Moreover, in the last five months the 10-year Treasury bond yield declined 100 basis points, providing substantial easing to the economy, and thereby doing some of the Fed’s work for it. In fact, the 10-year Treasury yield is more important than the fed funds rate to many homeowners and home buyers since mortgage rates are linked to the Treasury yield.

What a Cut Helps or Does Not Help

Credit card, or revolving credit rates are loosely linked to short-term rates so this should have a positive impact. But a 25 or 50 basis point cut will hardly be noticed by consumers since the average interest rate on retail store credit cards recently hit a record high of 30.45%, according to a new Bankrate study. The annual percentage rate (APR) on a credit card is the cost of borrowing, and it refers to the yearly interest rate paid on any balances, plus any fees. For example, the APR on the popular Costco Wholesale Corp. (COST- $897.27) Anywhere Visa card is currently 20.49%. So, while market watchers are eagerly waiting to see if the Fed moves 25 or 50 basis points, we believe there is little difference to consumers or the economy. Nonetheless, it is worth noting that revolving consumer credit reached a record $1.36 trillion in July and credit card delinquencies hit 3.25% in the second quarter, the highest since June 2011. There clearly is financial stress in many households and this is why the Fed needs to begin to ease.

Moreover, lowering the fed funds rate will definitely help the federal government deficit since 21% of outstanding marketable Treasury debt is currently held in short-term bills. By lowering short-term rates, the Federal Reserve will lower the government’s net interest expense. And according to current White House data, in 2023, the government’s net interest expense was 9.5% of total spending, extremely high when compared to the 9.9% of total outlays spent for defense and international.

Statistics on how the stock market reacts to an initial fed funds rate cut are quite mixed, although the market tends to decline on the day of the rate cut. Historically, the first rate cut occurs when the economy is already in a recession, although it may not have been known at the time since recessions are identified with a six-month lag. The one easing cycle that occurred prior to a recession was in June 1989, however, this cut was followed by a recession as well, but not until July 1990. Moreover, inflation of 6% or greater has also been followed by a recession, although it may take years to materialize. See page 3. In short, this cycle is unusual in many ways. And while the stock market believes we are headed for a soft landing and no recession, this means investors believe it will be different this time. We hope so but are not convinced that the economic cycle has been eliminated.

A Mix of Data

August data showed the CPI rose 2.5% YOY, down from 2.9% YOY in July. The PPI rose a mere 0.2% YOY versus 1.8% in July. The PCE deflator for August will be reported later next week, but it rose 2.5% YOY in July, unchanged from June. Core indices were less impressive. Core CPI rose 3.2% YOY, unchanged from July. Core PPI showed prices rising 2.3% YOY, up from 2.1% a month earlier. Core PCE for July was 2.6% YOY, virtually unchanged from June and May. In sum, the data remains mixed. See page 4.

Gasoline, and most fuels, were down at least 10% YOY in August, and this helped lower headline inflation in the CPI. Nevertheless, there were trouble spots in the report. Service sector inflation was 4.8% YOY, down from 4.9%. Services less rent rose 4.3% versus 4.6% in July. Transportation services pricing rose 7.9%, down from 8.8%. Auto insurance increased 16.5%, down from 18.6%, but still incredibly high. Health insurance rose 3.3% YOY, up from minus 0.6%. Hospital services rose 5.8%, down from 6.2%. Last but far from least, electricity rose 3.9% YOY, down from 4.9% YOY in July. Most of these indices were down from July levels, but still well above 3% YOY, and most importantly, these all represent necessities of most households. See page 5.

The National Federation of Independent Business indicated that its small business optimism index fell in August from 93.7 to 91.2, erasing all of July’s gains. Uncertainty rose from 90 to 92, reaching its highest level since 98 recorded in October 2020 during the pandemic. Eight of the 12 components we monitor fell during the month, two were unchanged and two rose. Job openings rose 2 points to 40 and plans to raise prices rose one to 24. See page 6.

As unemployment rises, small business owners tend to see weaker sales and that trend may be starting. With the unemployment rate moving above 4% we find that more businesses are reporting that weak sales are a major problem. However, inflation still ranks as the number one problem for a majority of businesses. While small business capital expenditure plans inched up to 24 in August, hiring plans fell two points to 13. Sales expectations plummeted from minus 9 to minus 18. Actual sales changes were unchanged in August at minus 16 but actual earnings fell from minus 30 to minus 37 in August. See page 7.

Conversely, initial statistics for September’s University of Michigan consumer sentiment index showed an increase from 67.9 to 69. This was a result of gains in both present conditions, up 1.6 points to 62.9 and expectations, up 0.9 points, to 73. Yet despite these gains the University of Michigan readings remain near recessionary levels. Conference Board consumer confidence indices for September will be released next week. See page 8.

The National Association of Realtors housing affordability index for July rose two points to 95.0 but it still remains below May’s level. The small increase was in line with a small decrease in the Federal Housing Finance Agency (FHFA) mortgage rate from 7% to 6.93%. The National Association of Home Builders confidence index rose for the first time in five months from 39 to 41. Single-family home sales rose from 44 to 45, expectations for the next 6 month rose from 49 to 53, and traffic of potential buyers from 25 to 27. Overall, these reports suggest the residential housing market remains sluggish but could be showing some green shoots. See page 9.

Retail sales for August surprised to the upside and rose 0.1% month-over-month while analysts were looking for a decline. On a year-over-year basis total retail sales rose 2.1% YOY, below the 2.9% seen in July and the 12-month average of 2.9% YOY. However, real retail sales fell 0.4% YOY, marking the 20^th time in the last 30 months that real YOY sales were negative. Unit vehicle sales fell 4.4% in August and were down 1.3% YOY. In general, vehicle sales have been trending lower since the April 2021 pandemic spike. See page 10. There were important changes in market breadth this week. The 25-day up/down volume oscillator is 4.07 and has been overbought for five of the last six days. With many of the indices at or near all-time highs, it is important for this indicator to confirm the advance with an overbought reading lasting at least 5 consecutive days. If the rally which began in October actually was a new bull market advance, it should also include several extreme overbought readings of 5.0 or better, which are typical of the first stage of a major advance. To date, the 4.07 reading is the best seen since December 2023 which is encouraging. This is the best demonstration of volume following prices seen since the end of last year.

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