And you just don’t get it, you keep it copacetic

“Bound for the Floor”, Local H

 

In an interview about the lyrics of their 1996 hit “Bound for the Floor”, frontman Scott Lucas explained the origin of the song’s most notable lyric “you keep it copacetic”, saying: “I love words that nobody uses anymore. Phrases and words that have been tossed on the scrap heap of linguistics. ‘Copacetic’ was a word I’d heard in war movies about Vietnam.”

At Wednesday’s Federal Open Market Committee press conference, Powell might not have gone to the “scrap heap of linguistics”, but he did insert a new buzzword into the central bank’s policy vernacular: recalibration.

He used the word nine times in Wednesday’s comments (funny enough, the only time “recalibration” was used at the prior meeting in July was by none other than the Fed Whisperer himself, the WSJ’s Nick Timiraos!).

Recalibration, in Fed speak, refers to moving policy from what they judge as a restrictive stance today to a neutral stance in order to “help maintain the strength of the economy and the labor market, and continue to enable further progress on inflation.” This is Powell wanting to “keep it copacetic” with the economy, trying to extend the expansion and avert a recession.

Powell cited the moderation in inflation data along with the “cooling” in labor market statistics as evidence for the ability and need to recalibrate policy by cutting interest rates, starting with a supersized 50 bps cut this week.

This characterization of the cutting cycle ahead, one of preventing not reacting to economic weakness, raises two important questions that we will explore in this Weekly Edge: how will rate cuts help extend the economic cycle and how far will the Fed cut this cycle if a recession is not imminent?

 

“What Good is Confidence”: How Will Rate Cuts Help Extend the Economic Cycle?

Powell began to seriously tee up this week’s interest rate cut back in December of last year, as he pivoted his commentary to say that rate cuts were “clearly a topic of discussion” and something that “begins to come into view” (almost as if he was singing along to Third Eye Blind’s epic and haunting “The Background”).

We kept the 3EB theme going that week with a look at “How’s It Going to Be” post the pivot, assessing various market outcomes as those rate cuts came “swimming into view.”

The conclusion at that time is that the indication and enaction of rate cuts and the recalibration of policy helps to ease financial conditions and boost business confidence, mostly in interest rate sensitive areas (to answer Local H’s question about “what good is confidence”).

In many ways, that is what has played out since Powell’s December pivot.

A great example is in bond market issuance. Despite Fed rates remaining elevated, interest rates fell across the yield curve post Powell’s December speech, while the risk-on mood allowed credit spreads to tighten (-65 bps since December, back near 2021 levels). This created a healthy backdrop for bond issuance this year, with total corporate bond issuance +31% YTD, including an +85% jump in high yield issuance (according to SIFMA data). This openness of bond market liquidity allowed companies to access capital at cheaper prices compared to prior years.

But not all parts of the economy have seen a relief from the anticipation of lower rates, with the enaction of lower rates a critical piece to ease funding costs for small and medium-sized businesses that rely on floating rate debt, such as from banks or private credit providers (though we note that credit spreads for this kind of debt have also tightened with the risk-on mood, with AAA CLO spreads at record tights).

This brings in the rationale for why Powell pushed so hard to go 50 bps to start the recalibration instead of a more measured 25 bps. High interest rates/funding costs have been a depressant of small and medium-sized business confidence and could have contributed to the fading hiring plans for these companies, as seen below.

As of: 9-20-24

Further, as Bloomberg’s Anna Wong has been flagging, this poor small business sentiment was captured in the recent sour-tempered Fed Beige Book. Powell has cited the Beige Book multiple times, including at December’s pivot and Wednesday’s cut decision, in his rationale for policy changes.

Thus, the lowering of interest rates could, in theory, help lift the mood of these smaller, interest rate-sensitive businesses. A rosier mood could then potentially boost future hiring plans and help stave off the recent slowing in job additions, given small businesses account for 46% of all jobs in the U.S.

There are also potentially stimulative benefits to be enjoyed by interest rate-sensitive sectors like housing. As interest and mortgage rates have fallen, we have begun to see a pickup in housing-related activity or at least excitement.

For example, as our Brian Nick flagged, Google search trends for “mortgage” have spiked in recent days as potential home buyers/sellers considering taking advantage of lower rates.

Source: Google, NewEdge Wealth, as of 9-20-24

Interestingly, these lower rates have not yet translated into higher mortgage applications for purchases, as shown below, but we have seen a jump in refinancing applications. As the great Ivy Zelman has been arguing, it may take until mortgage rates are closer to 5% to unfreeze the supply of sellers who are locked into low rate mortgages.

 

As of: 9-20-24

One important item to flag is if housing activity does pick up given lower rates, causing housing construction to pick up again, housing-related employment is still notably tight. This suggests that there is little slack in the housing-related labor market if activity were to pick up materially, of course, an odd, or Strange, backdrop for the Fed to embark on its largest non-recessionary easing cycle on record.

As of: 9-20-24

“Bound for the Floor?”: How Far Will the Fed Cut This Cycle if a Recession is Not Imminent?

This last point about the tightness of the interest-rate sensitive labor market for housing leads us to our second question about how far the Fed will cut this cycle if a recession does not present itself, as the Fed seeks to return to a “neutral” interest rate (one that is neither stimulative not restrictive to economic activity).

Said another way, if interest rates in this recalibration are now “bound for the floor” of neutral, where is that floor compared to prior cycles?

Powell answered that question in the press conference in this important excerpt:

“Intuitively, most—many, many people, anyway, would say we’re probably not going back to that era where there were trillions of dollars of sovereign bonds trading at negative rates, long-term bonds trading at negative rates. And it looked like the neutral was—might even be negative… My own sense is that we’re not going back to that but, you know, honestly, we’re going to find out. But, you know, it feels—it feels, to me, that the neutral rate is probably significantly higher than it was back then. How high is it? I don’t — I just don’t think we know. Again, we only know it by its works.”

The Fed has long talked about the neutral rate in its policy meetings, a very Greenspanian pursuit, but it is important to appreciate that this is the first cutting cycle that the Fed is explicitly targeting a return to a forecasted “neutral” rate, an estimate of which they have been forecasting only since 2012 (at an adorable initial level of 4.25%, which was subsequently cut to 2.5% over the course of the following “secular stagnation” decade).

The chart below shows how the current Fed funds rate is still significantly (over 200 bps) above the Fed’s own estimate of “neutral”. But if the neutral rate is in fact “significantly higher” than it was in the post-Great Financial Crisis period, we could see this floor under yields, assuming no recession, creep higher than the current 2.9% that the Fed and the bond market have forecasted for this cycle’s terminal rate.

As of: 9-20-24

We have long been discussing the reduced interest rate sensitivity of the broad U.S. economy this cycle (here and here are two examples of many that explain the multiple reasons for this economic resilience in the face of higher rates), and with Powell acknowledging the “significantly higher” neutral rate compared to the last cycle, we think this does suggest a higher floor for rates this cycle of recalibration, assuming no recession.

“And You Learn to Accept It”: Conclusion

Powell’s kick off to the recalibration cutting cycle and the questions that it raises highlight the incredibly Strange characteristics of this cycle overall. To begin a cutting cycle with a supersized, emergency-like cut when equity markets are at all-time highs, financial conditions are broadly easy, and total employment is at a record is a backdrop so unique that it is consistent with our Strange Landing expectations.

We do not think the Strangeness will end here, and remain vigilant about potential surprises to the path of the economy and policy, mostly as bond and equity markets grow increasingly confident pricing in both deep rate cuts and resilient growth.

IMPORTANT DISCLOSURES