On the back of last week's half-point cut in interest rates by the Federal Reserve Bank, equities and many commodities rallied anticipating continued growth in the U.S. economy. Why, therefore, did bond prices plunge?

 

Normally, after the Federal Reserve Bank begins an interest rate-cutting cycle, bond prices rally, and yields fall. But not this time. Economists were scratching their heads all week looking for answers. The explanation is straightforward.

 

For weeks before the meeting, many traders were betting that the Fed would be too slow to cut interest rates. And when and if they did it would be a small cut. That delay increased the probability that the economy would dip into recession quite soon. As such, investors bought bonds, the go-to safety trade in anticipation of a hard landing. That had sent bond yields down dramatically.

 

The Fed's larger-than-expected 50 basis point cut surprised traders and reversed that trade. Suddenly, the possibility of a softer landing for the economy has been vastly improved, especially after the Fed clarified that it was ready to match that cut in November if necessary. Buy equities and sell bonds was the new order of the day.

 

Chairman Jerome Powell acknowledged that the Fed's focus has shifted from the inflation numbers to the health of the labor market and the economy. He went to great pains to convince market participants in his Q&A session after the meeting that the economy was still strong, the inflation battle was all but over, and just about everyone was going to live happily ever after.

 

That may be so, but I have a different take on the Fed's actions. We are in an election year. Workers are voters and losing your job can sour one's outlook when deciding which lever to pull in November. Those in government are keenly aware of this. If given a choice between employment or inflation, what would you choose if you were the Fed?

 

The market's reaction to the news is understandable but remember it will be at least two years before the impact of this week's interest rate cut has an impact on the overall economy. Sure, some areas might see a boost sooner but not much. In the meantime, what happens to the economy?

 

The equity market and most advisors will tell you it is up, up, and away. And they are right, at least in the short term. I expect economic growth to continue to show decent numbers and would not be surprised to see a better-than-expected growth rate for the third quarter of this year. I also expect to see additional modest progress in reducing inflation. September and October's inflation numbers, I believe will show a  cooler Consumer Price Index, Producer Price Index, and the Fed's favored index, the Personal Consumption Expenditures Index. That should bolster the Fed's confidence that they have inflation licked.

 

By December, however, I am concerned that things may change. I fear we could see declining economic growth. It will be the result of the cumulative impact of the last two years of abnormally high interest rates.  This lag effect will outweigh the interest rate cuts of September and maybe November.

 

I am not predicting a recession, but only a slowdown, a "recalibration" to use the words of Fed Chairman Powell. Wall Street's interpretation of the Fed's new recalibration policy amounts to lowering interest rates quickly (faster for shorter). If so, it will lessen the blow to growth and ease us into a soft landing. But a soft landing would still be a period of slower growth.

 

At the same time, while the rate of inflation is falling, inflation is still rising, just at a lower and slower rate. And in the background, while inflation still lingers, we have an enormous budget deficit and rising debt load that is now taking more than $1 trillion a year to service. If we add on the stated intentions of both presidential candidates to increase spending by many trillions of dollars over the next four years, we have the makings of both a rekindling of inflation and a coming debt crisis.

 

Next week, we will examine what this could mean for the economy, inflation, the dollar, and the stock market.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.