The Fed's got your back

We've had a week to consider the consequences of what I think will go down as an historically aggressive move by the Federal Reserve to lowe

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We've had a week to consider the consequences of what I think will go down as an historically aggressive move by the Federal Reserve to lower interest rates by half a percentage point. Equity investors see the move as an unalloyed positive, with stocks having risen to new all-time highs. Bonds, meanwhile, have sold off slightly, understanding that the chances of a soft landing have increased, which should mean higher yields and lower bond prices. I think both of those moves are the right ones for the medium term. Stocks can hit new heights again and again as long as the economy holds, while bonds will have to wait for recession for their moment. I'll explain why in a historical context, hitting on the following points along the way: The Fed just took the worst outcomes off the table This is an unprecedented move for a couple reasons Now consider how this shows the Fed re-imagining its mandate for the future What if stocks fall despite a soft landing? Here are some precedents to consider The Kennedy Crash of 1962 is the big exception Given that context, here's what we should expect going forward, and why "buy and hold" makes sense

The Fed eliminated the left tail

In markets, the biggest fear is so-called tail risk. That's when, seemingly out of the blue, something happens that most participants previously viewed as a low probability. And then people are taken so much by surprise that they overwhelm the system with orders, rocking the market. Compared to a bell curve, the shape of outcomes in markets sometimes has "fat tails" because when markets are soaring or melting down, everyone crowds into the same trade. But it's the left tail, the bad outcomes, that people hate. And the Fed has effectively told the market, "We got this. You can pretty much rule those cases out." That's significant, because at times over the summer markets seemed almost panicked about the possibility of a recession. If that recession had come to pass, we would have seen a torrent of selling as everyone tried to de-risk at the same time. But, not only have the data held up and made an imminent recession a negligible risk, the Fed, by cutting a larger-than-standard half a point, makes that outcome even less of a risk going forward. Effectively, the Fed is prepared to cut massively if the data deteriorate any further. And they have another 5 percentage points of rate cuts to play with. This has never happened It might seem like a normal precautionary move on the Fed's part. In reality, though, this has never happened before. The central bank has never cut by more than a quarter point except in a recession. The Fed started targeting the fed funds rate in the early 1980s. And not once during that time has it preemptively done a jumbo rate cut to stick a soft landing. That is until now. I went back and checked. I found that every time the Fed went big on the rate cuts, it was because they had belatedly recognized that a recession — and potentially, a financial crisis — was right around the corner. This was true in 1991, as the Fed went big only after the economy was deep into a recession. The same was true in 2001, when policymakers cut only after the tech bubble had burst and the Nasdaq 100 was already down 45%. We saw the same panicky half- point response during the subprime crisis a month after BNP Paribas froze investment funds dogged by subprime losses and American Home Mortgage filed for bankruptcy even though it wasn't a subprime lender. The Fed was back at it one last time beginning in March 2020 as the world began to shut down because of the pandemic. Those are the only times the Fed went big. It was always after things had gotten so bad that they needed to cut to stave off a full-scale financial panic, something even cuts couldn't accomplish during the global financial crisis. By contrast, if you look at the recent data — from jobless claims to mortgage applications to retail sales — it shows a US economy nowhere near a recession. And stocks are near all-time highs. You've certainly never seen the Fed do a jumbo cut when equities were near records as they were last week. The Fed takes the dual mandate seriously To me, this is proof that the Fed has re-imagined its role. Originally, while ostensibly answerable to Congress, the Fed only had informal guidelines. So bad was the stagflation of the 1970s, though, that Congress introduced legislation mandating that the Fed take action, something that was codified in law in 1978 as the Full Employment and Balanced Growth Act.  Until recently, it was the inflation part of that dual mandate that was seared in the Fed's brain. Every time inflation popped up, the Fed would whack it down by tightening policy, at first by trying to control the money supply and then using the fed funds rate, the interest rate at which banks trade reserves overnight. In fact, the unofficial policy was preemptive under the premise that unemployment could actually get "too low". This notion was premised on a fictitious gibberish economic term called "the non-inflation accelerating rate of unemployment" or NAIRU for short. If the unemployment rate was below NAIRU, it was "too low" because tight labor markets would bid up wages, thus stoking excess demand and leading to inflation. So, the Fed would simply jack up rates at the risk of a recession — one they only avoided in the mid-1980s and the mid-1990s — hoping it would cool demand and inflation. That whole intellectual edifice is out the window now. What Fed Chair Jay Powell is telling us with the half-point move, is that the Fed is ready to act on the employment side of the mandate as much as on the inflation side. They would rather balance their approach to the presumed trade-off between employment and inflation and prevent a recession.  This is a completely new approach. Hence, the first jumbo cut without recession or crisis breathing down our neck.

What happens next? Look back

So what comes next depends on whether the Fed has come to the economy's aid in time. Policy acts with a lag. So we could still fall into a recession before the stimulative impact of rate cuts has an impact. I don't think that's likely. But realistically, we can only see forward about three or four months. And we do have the potential unwind of the AI investment bubble to contend with. Still, let's assume we power through and avoid a recession. If you review the entire post World War II period, sticking the soft landing for the economy is good for stocks. I verified this by looking back to see if stocks were "lower for longer" at any time during an economic expansion in the post-war era. I used the rolling 12-month return for the S&P 500 for my equity benchmark. And I used a 15% drop, a level halfway between a so-called correction of 10% and a bear market 20% loss, as my "lower-for-longer" metric. In the post-war era, there were about 10 such episodes. Six are associated with recessions and one was an outgrowth of the 1987 crash. Of the remaining three episodes, we can exclude 2022 as a good comparable because we are now seeing rate cuts instead of the hikes that caused that decline. That leaves 1947 and 1962.  The first instance saw GDP declines in both the second and third quarter, meeting the unofficial definition of a recession. Since the unemployment rate fell in an economy distorted by post-war demobilization, this wasn't ruled a recession by the NBER. But it's pretty darn close. So let's rule it out. The latter instance is more interesting, and it's the exception that actually proves the rule. The so-called Kennedy Slide of 1962, which also saw a flash crash in May of that year, has never been explained. The unemployment rate was declining and GDP growth was above 4%. Still, the worst 12-month shellacking an investor would have received was stocks down 17% year over year by the end of October 1962. But even in that instance, a year later, in October 1963, stocks had vaulted 30% higher. It's not time to be bearish The takeaway? Buy and hold works. The only time you saw any significant losses during an expansion was in 1962. And even then, had you waited out the freak slide in stocks, you would have been back in business within a year's time. De-risking in an expansion in anticipation of a recession just doesn't work. What's more, even if we go back to the recent 2022 episode of rate hikes that produced no recession, stocks slid but they were soon again at record highs when a recession failed to materialize. Rate hikes don't derail the fundamental underpinning driving stocks higher and that's corporate earnings. As long as the economy is expanding, we should expect the line on stock- market charts to go up and to the right. Now is no different. Bonds are a little different. Though I am more concentrated on equities here, there's an ongoing re-pricing of bonds going on now toward the downside. I don't think the losses will be significant, though, because the Fed has already told us it will preemptively cut aggressively if the economy slows or inflation decelerates. The two-year yield now near 3.5% could go back toward 4%. But I think that's about the maximum we'll see for now. US 10-year notes are more vulnerable. But they are already yielding about 3.75%. So the losses will also be manageable. The bond story is mostly about locking in yield for the greatest maturity your risk appetite will allow before the Fed lowers interest rates. One final word on other assets like corporate bonds, high yield securities or even Bitcoin. Since the Fed has told the markets, "I've got your back," I don't see those asset classes declining either. More likely is that people take on too much risk, buoying those assets artificially until hints of a recession appear again. Buy and Hold Ultimately though, the biggest lesson in all of this is that buy and hold works. Equities don't drop and stay down for more than a year or so during an economic expansion. We saw that in 1962, in 1987 and again in 2022. The real question is about what to do during recessions. The conventional wisdom is that you should ride them out. And doing so in March 2020 would have been the right strategy in retrospect. So aggressive was the policy response, the recession only lasted a couple of months, giving a bear market no time to fester. Given the Fed's new approach to its dual mandate, 2020 may be the blueprint going forward, too. But I am still troubled by the concept that you can buy and hold your way to retirement without worrying one iota about the economy or the actual composition of your investment portfolio. This approach of investing in low-cost index funds and holding through minor market hiccups has certainly worked for the better part of 15 years, with a little help from the Fed. But history tells us that markets can and do collapse without making investors whole for several years. It is thus still important to take stock of overvaluation when you see it and economic downturns too. At some point, de-risking might be the right approach, just not yet.

Things on my radar

The decline in interest rates is already triggering a wave of mortgage refinancing. As an aside, remember we still have commercial real estate problems. Some are being re-done into residential rentals. On the other side of the world, global growth is getting a boost from the biggest one-year policy rate cut in Chinese history. Read this to get a more nuanced take on what China's stimulus means. Also: Take the MLIV Pulse survey What's the best trade for the rest of the year? Share your views.

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