CIO Insights: Fed rate cuts have begun – here’s what it means for your investments

8 minute read

The US Federal Reserve (Fed) has officially begun its interest rate cutting cycle with an outsized cut of 50 basis points (bps). This move signals a significant shift in the central bank’s monetary policy stance, with its focus turning from taming inflation to supporting growth. And for investors, declining rates makes it even more important to put your cash to work in investment portfolios.

In this month’s CIO Insights, we'll explore the implications of the Fed's decision on the economy and what it means for your investments.

Key takeaways:

• The Fed kicked off its rate cut cycle with a bang. Starting off an easing cycle with a 50 bp cut is not unprecedented, though the Fed has rarely cut by this much outside of a crisis or recession. That said, we do not believe we are at the brink of either scenario. (Our last CIO Insights, Why US recession risks may be overstated, details why.)
• The central bank’s focus has shifted to supporting growth. We think the Fed’s reasoning behind its latest move is two-fold: First, the combination of easing inflation and a cooling labour market means it’s shifted its primary concern from inflation to growth. Second, it wants to send a clear message to the market that it’s not “behind the curve” in working to avoid a recession.
• Downside risks to growth are lower, but upside risks to inflation have risen. Given the Fed’s latest actions, the risk of a recession in the near-term has been lowered. However, there’s also a higher risk that the Fed may have a tougher time bringing inflation back down to its 2% target given supply-side constraints.
• An “inflationary growth” regime is supportive for risk assets. A key implication of the Fed’s latest move is that our Economic Regime-based Asset Allocation (ERAA®) framework may remain in the current regime of inflationary growth for longer. Under this regime, ERAA® has allocated to asset classes that can benefit from an environment of economic expansion – including a greater emphasis on equities, and increased allocations to higher-yielding bonds.
• Falling cash rates and better growth prospects add to the case for putting your cash to work. Keeping your money in cash and fixed-deposit products will become progressively less attractive as the Fed continues to cut rates. So if you’ve been utilising these for a larger portion of your funds, now may be a good time to think about putting that cash to work in other asset classes like bonds and equities.

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The Fed kicked off its rate cut cycle with a bang

The Fed’s decision to start its easing cycle with a 50 bps reduction, while not unprecedented, is a more substantial cut than its typical initial decrease of 25 bps. To put this in context, the last times the Fed started with such aggressive initial cuts were in 2007 and 2001 – both periods of significant economic stress.

So why did they go big this time? We see two main reasons:

1. Shifting its focus from inflation to growth 

The Fed has clearly reoriented its primary concern from taming inflationary pressures to maintaining economic growth: as of its September meeting, more Federal Open Market Committee (FOMC) members see a greater chance of the unemployment rate increasing compared with earlier this year (that’s reflected by the light blue bar in the left chart below).

On the other hand, most now see balanced risks to inflation – meaning they believe inflation is just as likely to rise as it is to fall (as shown by the light blue bar in the right chart).

2. Demonstrating its proactive management of the US economy

By starting with a larger-than-usual cut, the central bank has sent a clear message about its readiness to act decisively to support the economy. Even though the Fed still characterised the economy as “strong”,  it demonstrated a willingness to reduce rates to maintain the labour market’s strength, and to further adjust policy should the economic data weaken further.

That’s reflected in the "dot plot" chart below. Each dot represents an FOMC member’s projections for the federal funds rate, with the teal line showing the median: a further 50 bps of rate cuts by year-end. The black line represents market expectations based on futures prices. While the Fed's projected rate path still shows a slower pace of cuts than what the market expects, that gap has narrowed compared to earlier this year.

What the Fed’s shift means for the US and global economy

Monetary policy is an important driver of the economic cycle. This bold move by the Fed shifts the economic outlook for the US in a few important ways:

1. US recession risks have been reduced

While there has indeed been a cooling in the labour market, the unemployment rate is still at historical lows. (We outlined this in last month’s CIO Insights, Why US recession risks may be overstated.) Our analysis finds that the US consumer is still strong, and election-related uncertainty may be contributing to softer economic data. 

And with this decision, the Fed has signalled its willingness to step in to support financial markets. We also believe that its latest move has further reduced the probability of a recession in the near term.

2. But inflation might be harder to get back to target

Here's the tricky part: While we're less likely to see a recession soon, it might now be harder to get inflation down to the Fed's 2% target. The current situation reminds us a bit of 2007.

Back then, the Fed's starting cut of 50 bps and subsequent rate cuts initially gave a boost to stocks. But coupled with strong demand from emerging markets like China, rate cuts also boosted the prices of commodities and ended up fueling inflation in 2008. 

Now, considering the current interest rate cycle, while history may not repeat itself exactly, this experience suggests that investors should remain cautious about the potential for inflation to stay sticky.

3. Greater global liquidity could further support asset prices

Adding to all of this, financial conditions indicators – measures of how accessible financing and credit are for households, businesses, and governments – point to a favourable environment for global liquidity. This means that money is able to flow more easily through the financial system. 

What’s more, the Fed has also started to slow its quantitative tightening (QT) and may conclude the program in the months ahead. This also means more cash in the financial system, which typically drives demand for risk assets. In short, both of these factors are supportive of asset prices.

ERAA® is likely to remain in a regime of “inflationary growth”

What does this mean for asset allocation going forward? As a quick reminder, our ERAA® investment framework uses real-time economic data to determine where we are in the economic cycle, and optimises your portfolios for it. Since this past April, we’ve been in a regime of inflationary growth – which meant a greater emphasis on equities, and increased allocations to higher-yielding bonds.

With the latest move from the Fed, our expectation is that ERAA® is likely to remain in this regime for longer. Like the Fed, our decisions will remain data-driven.

Falling rates mean it’s time to put your cash to work

As the Fed continues to cut rates – and as other global central banks likely follow suit – the interest that banks offer on your savings will naturally start to decline. So if you've been keeping your money in cash, now might be a good time to think about investing some of it. Here's why:

1. Your savings in the bank or in cash products such as fixed deposits will earn less: Lower interest rates mean your cash savings won't grow as much over time.
2. Potential for better returns on other assets: A well-balanced investment portfolio could earn you more in the current economic climate. For example, our ERAA®-managed portfolios – which comprise a mix of assets – have generated returns of between 5.7% and 15.3% in USD terms for the year to mid-September*, outperforming the return on just holding cash.
   

But remember, investing always comes with its risks. Before you make any changes to your portfolio, consider your time horizon – how long you intend to keep your money invested – and risk appetite – how much risk you're comfortable taking. 

* Performance figures are before fees. Model portfolio returns are expressed in gross terms before fees, withholding taxes, and reclaims on dividends. They are provided only as a gauge of pure performance before other items. Actual account returns may deviate from the model portfolios due to differences in the timing of trade execution (e.g. during the day vs close), timing differences and intraday volatility of reoptimisation and rebalancing, fees, dividend taxes and reclaims, etc. Past performance is not a guarantee for future returns. 

Glossary

Federal Open Market Committee (FOMC)

The branch of the Fed that determines the direction of US monetary policy. The FOMC is composed of the seven members of the Board of Governors and five Reserve Bank presidents.

Easing cycle

A continued period during which a central bank lowers interest rates and adopts other supportive monetary policies to stimulate economic growth.

Quantitative tightening (QT)

A central bank policy to reduce the money supply in the economy by selling securities or letting them mature without reinvesting, effectively shrinking the bank's balance sheet.

Risk assets

Investments that carry a higher degree of market risk but offer the potential for higher returns. These typically include stocks, some commodities, and some types of bonds.