What are the Fed’s possible considerations on rate cuts?

When you take all the observations above into account, and combine it with Powell’s previous comments when inflation erupted that the Fed’s models were broken on forecasting inflation, then it is reasonable that the Fed is hesitating to cut the policy rate.

It is all about real rates

What are some of the considerations that the Fed should weight in relation to cutting the policy rate?

• Banks are indicating beginning cracks in the commercial real estate market and easing the policy rate would pre-empt the negative impact. It is important to note that yesterday’s NYCB announcement was related to their rent-regulated multi-family apartments.
  
  
• The inflation rate seems to generally coming down and the forward-looking inflation swaps are pricing 2.1% inflation over the next year. Keep in mind though that these markets are not very good at predicting anything.
  
  
• But taking the above point on inflation at face value the Fed is significantly restrictive in its policy rate indicated by a real rate of over 300 bps which increases the risk of an abrupt recession.
  
  
• With the US government running a 6.5% fiscal deficit over the past year the deficit will for sure come down towards the historical average around 3% causing a negative impulse from government spending over time. Rate cuts will mitigate this negative impulse.
  
  
• Monetary policy and credit conditions come with a lag and already now we observe the longest lag in monetary policy since the early 1970s due to the excessive fiscal policies. Acknowledging those lags means that the Fed should prepare for downside risks to the economy in the coming quarters.
  
  
• The estimated neutral policy rate according to the Fed is around the 2.5%, so if that estimate is correct the longer the Fed stays above 5% the more pain will follow.
  
  
• The long period with low bond yields means that it takes a quite a bit of time for refinancing of debt to kick in, but the refinancing wave is beginning to meaningfully impact credit for companies.
  
  
• Geopolitical risks are a downside risk to the economy and are on the rise.

What are some the ways to express your views on the Fed?

If you believe the Fed will start the cutting cycle in May and then go aggressively towards the neural rate then technology, car, renewable energy stocks should be the segments within equities with the highest positive response function to lower policy rates because of their high equity valuations (technology and renewable energy) and high capital requirements (car industry). If one wants to express the view that the economy will cool down fast and that the market is wrong on rate cuts (too few rate cuts priced in) then this is done in SOFR futures. One would be long the SOFR Mar-2025 contract if one believes the Fed must be more aggressive on monetary policy than what is priced in.

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