Macro
This week, the market has been digesting the first rate cut of the current cycle. The Fed began its easing with a jumbo 50 basis point cut, managing to avoid spooking the market. While the market had priced in nearly a two-thirds chance of a 50 bps cut the day before, the size still surprised some observers. With the first cut set at 50 bps, the probability of a soft landing has increased, and financial conditions have eased, boosting risk asset pricing.
Jerome Powell skillfully navigated market expectations, explaining that the large cut was due to a positive outcome on inflation rather than concerns about growth. He emphasized that this cut should not set the pace for future moves, and further policy recalibration will depend on upcoming data.
Powell also mentioned that monetary policy needs to be less restrictive, though this restrictiveness needs to be visible in the economic data. GDP remains strong, U.S. retail sales are healthy, and industrial production recently exceeded expectations. The only weakening area is the labour market, which is starting to slow but from a very strong position.
Market observers, seeing this economic strength despite restrictive monetary policy, argue that the Fed’s neutral rate should be raised from the current 2.9% to closer to 4%. Until recently, markets anticipated drastic rate cuts by 2025, possibly influenced by a post-GFC recency bias. The fiscal backdrop also supports a more elevated neutral rate, with a large deficit continuing to put upward pressure on yields.
Historically, the Fed has cut rates when apparent economic trouble is already priced into the market. Since the 1990s, no easing cycle has begun, with equity valuations and financial conditions as elevated as they are today.
Rates
The market reaction to the Fed’s rate cuts was particularly interesting on the longer end of the curve. The rise in the 10-year Treasury yield following the cut was driven entirely by an increase in real yields, not by inflation expectations.
This suggests that investors are concerned about the Fed’s outsized stimulus potentially overheating the economy, which could lead to demand-driven inflation. Additionally, rising shipping costs pose a risk of reigniting supply-driven inflation. In general, the ongoing global easing cycle is steepening yield curves across rate markets.
Following the Fed’s substantial rate cut, the yield curve has regained focus as traders attempt to interpret its fluctuations and what they signal for economic growth. Historically, the yield curve’s shape has been linked to the economy’s health, but many believe the current situation is different. The 2s10s curve is steepening faster than in previous cycles, driven by rising long-term yields outpacing short-term yields.
Recent PMI data has diverged from ISM figures, which could keep yields climbing. Monday’s PMI figures will be an important input, and if they increase, they could push yields slightly higher. Money markets reflect this uncertainty, with funds showing reluctance to buy longer-term Treasury bills, indicating that the decline in yields may have been overdone. There is also hesitancy about the long-term outlook.
Credit
Corporate bond markets are experiencing a surge in deals following the Federal Reserve’s recent 50 basis point rate cut, as companies rush to tap debt markets. Many firms are securing financing ahead of the U.S. election, aiming to lock in favourable borrowing conditions while demand remains strong and yields continue to trend lower. So far, investment-grade (IG) sales in September have exceeded expectations, reaching $131 billion, compared to a forecast of $125 billion, and surpassing figures from September 2023 ($124 billion) and September 2022 ($78 billion).
Sales in the U.S. high-grade bond market have increased by 29% year-over-year, while junk-rated companies have issued $222 billion in bonds, outpacing last year’s total of $176 billion. The leveraged loan market has also been experiencing its busiest year since 2017, underscoring the strong demand for corporate debt financing.
Default rates are declining. However, heading into the U.S. election, market volatility may increase, potentially widening credit spreads. Moreover, the risks are skewed to the downside, with current valuations at elevated levels.
Equities
The S&P 500 closed at a record high on Thursday, rising 1.7% to 5,713.64, driven by investor optimism that the Federal Reserve’s half-point interest rate cut would help ensure a soft landing for the U.S. economy. This move triggered a global rally, with gains across European and Asian markets. The S&P 500 also set a new intraday peak of 5,733.57 before slightly pulling back. S&P 500 slid down 19 bps on Friday to finish the Week 1.36% up, at 5,702 points. While much of the market’s gains have been driven by large-cap companies, the equal-weighted S&P 500 (SPW) also hit record levels, unlike the Nasdaq 100 (NDX) and Russell 2000, which have seen the largest multiple expansion this year.
The Fed’s rate cuts, aimed at controlling inflation and promoting growth, have been particularly favourable for high-growth sectors like technology, which led to the market’s gains. The tech-heavy Nasdaq Composite surged 2.5%, and the small-cap Russell 2000 climbed 2.1%, while defensive sectors like consumer staples and utilities lagged. Interestingly, the Real Estate sector, which has been performing very strongly since the end of April, has pulled back this week despite the rate cut.
Investors have shown growing interest in value and small-cap stocks in response to the Fed’s dovish approach and the 50 bps cut. Fed Chair Jerome Powell’s reassurance that a recession is not imminent has further boosted confidence in value stocks. In September alone, value ETFs attracted $21.2 billion in inflows, well above the $11 billion collected in August. On September 18, following the Fed’s rate cut, value ETFs saw $4.7 billion in inflows. However, value stocks have underperformed other strategies this month, with a return of -1.32%, compared to 0.64% for high dividends and 0.51% for growth stocks. The increased flow into value ETFs suggests investors buy at lower prices, anticipating a recovery in value stocks.
After a surge in interest rates in 2022, U.S. share buybacks declined significantly in 2023, totalling $795 billion—a 14% decrease from the record $922 billion in 2022. This decline, one of the sharpest since the 2008 financial crisis, was primarily due to higher borrowing costs and concerns about a potential economic slowdown. However, in 2024, buybacks have made a strong comeback. S&P 500 companies repurchased $472 billion worth of shares in the first half of the year, a 21% increase compared to the same period in 2023.
Companies are likely to accelerate buybacks ahead of a planned increase in the buyback tax rate, which rose from 1% in 2023 to 4% by 2025. Following the Fed’s 50 bps rate cut, buybacks are expected to accelerate further. Goldman Sachs projects that buybacks will reach $925 billion by the end of 2024 and surpass $1 trillion in 2025.
Buybacks are typically advantageous as they are taxed more favourably than dividends (currently at a 1% tax rate, rising to 4% next year) and can boost earnings per share (EPS) by reducing the number of shares outstanding, even if overall profits remain flat. They are particularly beneficial when companies repurchase shares below their intrinsic value. From another perspective, buybacks are often viewed as a positive signal, indicating that CEOs, with their insider knowledge, believe their shares are attractively priced.
However, shareholders should be cautious about excessive buybacks, which can drain liquidity and potentially harm future growth by affecting long-term investments.