Why This Latest Fed Cut Is Different...

Amber Hestla's picture

Thursday, November 7, 2019 - 12:00am

by Amber Hestla

The big story last week was the Federal Reserve. The Fed meets every six weeks, and, for the third consecutive meeting, they cut rates.

That's the story. As investors, we need to dig behind the story and look at why the Fed cut rates.

Interest rates are one of the Fed's most important policy tools. They use interest rates to fine tune economic growth. This is based on the theory that excessive growth causes inflation while slow growth creates unemployment. In theory, the Fed tries to ensure interest rates are just right so that we see growth without high inflation or unemployment.

Cutting rates generally means inflation is low and unemployment is rising. It's the kind of situation we see before a recession.

But this time is different.


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Now, inflation is low. The chart below shows the year-over-year change in the consumer price index. It's been consistently below 2% for the past few years.

With inflation well below its long-term average of 3.5%, the Fed doesn't seem to be concerned about inflation. Based on history, if inflation is contained, this would tell us the Fed is concerned with unemployment.

The Fed generally cuts interest rates when unemployment is high so that businesses will borrow money to create jobs.

But unemployment is also low.

Unemployment was lower in the mid-1960s and early 1950s, times when the United States was exporting prosperity as the rest of the world rebuilt after World War II. In those cases, the Fed was raising interest rates.

In the next chart, I've added the Fed's discount rate (red line) to the chart. This data series ended in 2002 when the Fed began using the fed funds rate to fine tune the economy. The chart shows the Fed was raising rates when unemployment was low in the past. It also shows the Fed was usually raising rates as the recession began.

The next chart shows the fed funds rate as the red line and shows a similar pattern. The Fed raised rates before the last two recessions started but began cutting in the months ahead of the actual recession.

What All Of This Means

It seems like the Fed has gotten better at spotting recessions. This chart shows policy makers are attempting to reduce the impact of the recession in the months before the recession begins.

This could be a repeat of the recent past, with the Fed reversing course right before the economy slows. Or, maybe this time, the Fed gets it right and their policy moves lead to us avoiding a recession that appeared to be inevitable.

Of course, we can't know if the Fed will successfully avoid a recession, but we do know they are trying. Fed policies are adding billions of dollars a month to the economy and ensuring credit markets remain liquid. That is bullish for the stock market, and that explains why the S&P 500 ended the week at a new all-time high.

The chart shows that prices recently completed an extended consolidation and are now in a clear uptrend. While large-cap stocks offer significant potential into the end of the year, mid-cap stocks could be even more rewarding.

The S&P 400 Index, a benchmark for mid-cap stocks with market caps between about $1.5 billion and $7 billion, is close to its all-time high. It's also on a Profit Amplifier Momentum (PAM) "buy" signal on the monthly chart shown above. PAM is also bullish on the weekly and daily charts.

PAM is a momentum indicator I've developed to time short-term trades. Signals on monthly charts, as shown above, tend to be long lasting. We could be at the beginning of a multiyear move in mid caps, and this group of stocks often outperforms large caps.

Action To Take

With the Federal Reserve supporting the economy, now is an ideal time to consider investments like mid-cap and small-cap stocks. With bullish seasonal patterns into the end of the year, we are likely to see large gains in these sectors.

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Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.