The more things change…
There have been some changes over here at AFE. You probably know a few of them if you’ve chatted with Forster recently. New platform, new people, new firm. I am a new here, as is everyone else really, excepting Ryan (and Jordan, and Anderson). Stop by and say hi, our lovely faces are now on the website.
We intend to increase the level of communication with clients and friends. Having a plan in place that will weather through the vicissitudes of an economic cycle is key, and our clients have that. This should lead to peace of mind for most. But you see, we have opinions, and our spouses at home get tired of listening. So, from time to time we’d like to provide updates on what we are seeing, thinking, and reading. We hope this will do several things for our clients:
- Educate – most people can’t spend all day every day studying markets and the economy. For us this is an important part of the job.
- Elucidate – There is a lot of information being constantly thrown at us, some simple to digest, other bits more involved. We hope to find signal in the noise and to the best of our ability make the complex simple for others.
- Entertain – Because as a bumper sticker in the golf course parking lot from my youth as I trudged into the caddy shack at 5am would remind me, “If it’s not fun, why do it?”
(You’ll notice a theme. We like the letter “E” here. It’s part of the Experience. We also like aggressive alliteration).
When I left banking for wealth management, I was surprised by many CFPs, who tend to focus on “tax alpha” and the blocking a tackling of financial planning. I had worked hard to become a Chartered Financial Analyst, an important designation in the world of investing. And yet, most CFPs gave me the impression “that’s nice, but not necessary.” The reason for this (besides jealousy) is that it is darned hard to beat the market on a consistent basis. So hard, that one should really focus on basics of planning: develop a solid plan for a client that will build wealth over time, work to reduce the lifetime effective tax rate, put estate planning in place, and modify as needed for changes in the client’s life circumstances. This makes perfect sense—focus on what you can control! We at AFE agree with this approach, and don’t profess to have a crystal ball (Alec might, but he’s been mum on that).
That said, we think we’d be doing a disservice to our clients if our mentality was just “take what the market gives you” and bury our heads in the sand without at least some view to how the markets will play out in the medium to long term (say 3+ years). Zooming out has its advantages, and like a magic eye puzzle potentially brings clarity. It is to this broader view that we will focus and share our thoughts, with the occasional musing on current market happenings as they relate to the bigger picture.
With that preamble concluded, we would like to discuss the recent 50-basis point rate cut, and the possible rationale behind it.
On September 18th the Fed Chair Jerome Powell announced a 50-basis point rate (0.50%) to the Fed Funds Rate (FFR), which is the benchmark rate that banks use to lend each other money. This brought the Fed Funds Rate down from 5.25%-5.50% to 4.75%-5.00% and was the first rate cut since the Fed began its 500-basis point hike that commenced March 2022. Note that the FFR is a range, as it is set by the Federal Reserve of New York going out into the market and actively buying and selling securities, thus increasing or decreasing the reserves held at banks. The Fed does this in hopes that by increasing bank reserves, it will increase bank lending and stimulate the economy (or decrease overall bank reserves to decrease lending).
We see that Powell is stimulating the economy (Powell might argue that he’s moving interest rates to a more neutral stance where they neither help nor hamper business—the fabled “neutral rate.”). Which is curious, since the S&P has had 42 record highs this year this far, unemployment is at a rather low 4.2%, and credit spreads are tight (the difference in yield between a bond and Treasury bond of the same maturity—larger credit spreads suggest that investors perceive risk and need a higher return to justify holding the riskier bond). The S&P is not the economy, but it is a decent barometer and leading indicator (per the Motley Fool, 62% of Americans own stocks). The latest GDPNow estimate from the Atlanta Fed for GDP growth for Q3 is 3.1%. Observers can be forgiven for asking “why cut now?”
Powell himself cited concerns around the employment market, moderating inflation, and support for economic growth. Powell is cutting rates preemptively, before real problems surface. This is interesting because the last time the Fed cut 50bps was March 2020, 2008 before that, and 2001 before that. Each time during a legitimate crisis. And now, in 2024? Now the Fed wants to be proactive, before issues surface.
Far be it for us to gainsay the Fed and its 400+ PHDs, but we can’t help but feel there’s a little more to the Fed actions. It helps to remember how the Fed is organized. It is a public-private structure made up of 12 regional Federal Reserve Banks, technically owned by member banks, with a board of governors in DC that are nominated by the President and confirmed by the US Senate. Additionally, the Fed remits its profits to the US Treasury. Except in 2023 it lost a record $114.3 billion, largely in part to hiking the rates and having to pay out more to banks at a higher rate than the securities on its balance sheet yielded.
So the Fed is politically independent, except its governors and the Chair are political appointees and all the profits go to the government. Got it.
The Fed’s clients/shareholders (banks, not you or I) were caught off-sides by the rate hikes, and their balance sheets have the bruises to prove it. Several large banks went under in 2023, most notably Silicon Valley Bank. The good news for banks is that if they don’t have to sell securities that are underwater, the losses don’t have to be realized (i.e. affect the profit and loss statement). And the Fed created the Bank Term Funding Program so member banks could borrow from the Fed at par against impaired assets—the Fed waived a wand and made the pain go away. Lowering rates will bring relief to these banks over time.
Forbes
Perhaps more importantly though, the US government can’t afford higher rates indefinitely. Interest expense on the $35+ trillion in debt is north of $1 trillion now, making it the third largest line item for the government, after social security and Medicare, more than what we spend on health or defense, and 3x what we spend on education. By decreasing rates, the Fed will lower the cost of borrowing for the US government. An estimated $7.6 trillion (22% of the total $35.3T) is coming due/has come due in 2024, and given the reliance on short-term funding recently, that figure will only increase in 2025.
FRED
While rate cuts will help the consumer, those individuals and businesses utilizing lines of credit, it will also help US banks and the US government. What’s the downside? Easier conditions, increased lending, continued government deficit spending all contribute to potential inflationary pressures. Fortunately, those look muted for now, but it’s something we will watch.
If your spouse doesn’t care to talk about this stuff either, or you want to think through how to put these ideas to work and build your financial future, we’re always happy to chat!