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Why is the Fed going to cut rates this month…and will it work?

As the chart below shows, PCE inflation (green line) was 2.5% in July, the same as June. Core PCE inflation (blue line) was 2.6% in July, the same as June and May. Median PCE inflation (orange line) ticked down to 3.2% from 3.3% in June.

Median PCE

Fed Chair Jay Powell’s favorite inflation measure, SuperCore PCE, rose 3.3% in July, the same as in June and in December 2023, as shown below. Also, the latest jobs report showed average hourly earnings rose 3.8%, up from 3.6% the prior month.

Supercore

Clearly, the Fed’s “fight” against the inflation they created when they increased the money supply by 40% in response to the government covid lockdowns has stalled in recent months. And underlying inflation is still more than 50% higher than the Fed’s arbitrary 2% target.

And what happens if inflation re-accelerates from here, as it did back in the “stagflationary” 1970s, as this chart shows?

1970s 1920s

Source: ZeroHedge

So why has the Fed decided to cut rates now?

The Two Real Reasons The Fed Is Cutting Rates

There are two main reasons the Fed is likely to start a long rate cutting cycle this month.

The first reason is that the Fed always follows market rates, particularly the 2-Year Treasury rate, when setting the Federal Funds rate. This is because the Fed has no other rational way to set interest rates, since only market-driven rates make any sense economically. As shown below, the 2-Year rate (red line) always leads the Federal Funds rate (blue line), both on the way up and on the way down.

FF and 2 year

The second reason is that the Fed’s army of economists understands that a recession is inevitable after an aggressive rate hiking cycle that causes an inverted yield curve. This is not a secret. And the Fed can see that it is already causing a weaker economy and labor market. The Fed knows that a weakening economy is the primary reason the 2-Year yield is falling. They know the last four recessions occurred an average of 15 months after a peak in the Fed Funds rate (we are currently in month 13) and after the Fed began cutting rates.

They have probably also seen this graph, which tells them that a recession (shaded gray) typically starts after the 10-Year/2-Year yield curve spread un-inverts (turns positive), which it just did.

Yield curve

The Long Inversion Period Is Very Bearish

As the chart below shows, typically the longer the 10-Year/2-Year yield curve has been inverted, the deeper the stock market falls. The yield curve has been inverted for more than 700 days. The only other time the yield curve was inverted that long was in 1929, before the start of the Great Depression, when the Dow Industrials collapsed 90%. We do not expect the same policy errors of Herbert Hoover this time (although we can’t rule it out), so we do not expect that much of a decline, but we believe a 50% to 70% decline is likely.

Inversion days

Source: Game of Trades

Given the long rate hiking cycle and the long yield curve inversion, we expect a long rate cutting cycle. Currently the Fed is targeting over 2% of Fed Fund rate cuts over the next two years.

We expect it to start on September 18 with a 0.25% rate cut. We think the Fed will not cut by 0.50% because they do not want to scare Wall Street…yet.

Metals Don’t Lie

Unlike the bureaucrats at the Fed, metals don’t lie. The chart below shows the recent major divergence between copper (black line) and gold (gold line) in the top clip. Copper is an industrial metal, so a stronger economy drives higher prices and a weaker economy drives lower prices. The recent 20% decline in copper suggests the economy is weakening. Meanwhile, gold has been rallying on persistently high inflation, more Fed money creation to come and increasing economic and political uncertainty. The ratio of copper to gold in the bottom clip shows copper has been underperforming gold since most stocks peaked in late 2021. We believe the latest leg down is likely coinciding with the recognition that a US recession is starting.

copper gold

Investment Implications

With inflation remaining above the Fed’s 2% target more than two years after they started hiking rates, they have clearly not “won” the fight against the inflation they created. But they are going to cut rates, as they always do, because market rates are falling because a recession is starting.

The Fed will likely create massive amounts of new money over the coming years, but it usually takes a couple of years before monetary policy impacts the economy, so we do not believe Fed rate cuts will prevent a recession. Rate cuts did not prevent prior recessions, including the recessions in the early 2000s and 2009-2009. All this new money should be a boon for commodities over the long-term, particularly gold and silver, which are very undervalued compared to equities.

Investors should be prepared for a wild ride over the next couple of years.

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