Earlier this month, the Federal Reserve reduced interest rates by 25 basis points, introducing a new target range of 4.00% to 4.25%. Additional rate cuts are possible before the end of the year according to the Fed’s projections.
The news sent stocks to an all-time high, as all three major stock indexes—the S&P 500, Dow Jones industrial average, and Nasdaq composite—hit new peaks. The Nasdaq, which is comprised of more than 3,000 stocks, led the pack gaining 0.9%.
Yet not all observers shared the market’s enthusiasm.
Fed Chair Jerome Powell urged caution and told reporters after the meeting:
“There are no risk-free paths … It’s not incredibly obvious what to do.”
Given the Personal Consumption Expenditures (PCE), a barometer for inflation, index at 2.9% and above the Fed’s 2% target, Powell’s skepticism is justified. Reducing rates only increases inflation risk, as it makes money easier to borrow.
Jeffrey Gundlach, CEO of DoubleLine Capital said the Fed’s 25-point cut was the right move but warned that aggressive rate reductions could stoke inflation.
Elevated grocery prices aren’t the only concern. Equity markets are starting to look inflated as well.
The S&P 500 currently trades at a price-to-earnings ratio of roughly 30, double its historic average of 15. This is coupled with an earnings yield of just 3.24%, around half its average of 7.22%.
Investors today are paying more for less, compared to a few years ago when the S&P 500 offered a 5% yield for 21 times earnings.
With more cuts likely to happen, exuberance in public markets might linger for a little longer, keeping company valuations buoyant.
This came to fruition a day after the Fed cut rates, when U.S. companies issued nearly $15 billion in investment-grade bonds, sending an influx of liquidity into private credit.
As a result, credit spreads between investment-grade corporate bonds and U.S. treasuries tightened to 72 basis points, a shocking 27-year low.
This means one of two things:
Investors are confident that corporations will manage their cheap debt diligently and provide returns above the cost of borrowing.
Or, more cynically, investors are underpricing risk, piling into corporate debt to capitalize on any extra yield before rates decline further.
The latter proposes a dangerous scenario in conjunction with public valuations.
So why are rising stock prices and increased levels of lending a bad thing?
On the surface, both seem possible. Rising equity prices boost consumer confidence, and cheaper debt gives companies the ability to pursue more profitable projects. But when both happen while inflation is running above target, it puts the Fed in a difficult position.
Even a slight change in the Fed’s game plan can drastically shift market sentiment, especially when investors aren’t pricing that in.
William Campbell, a portfolio manager at DoubleLine Capital warned:
“This administration needs to be careful in their attempts to ease financial conditions and monetary conditions; overdoing it or pushing it to an extreme will have the opposite effect, and our biggest concern is that the back end of the curve more and more will reflect concerns about inflation expectations and the fiscal outlook.”
Others remain more optimistic.
Sara Devereux, Global Head of Fixed Income at Vanguard, said:
“Credit spreads are near historical lows, but healthy fundamentals, attractive all-in yields, robust investor demand, a proactive Fed, and low recession risk support current valuations.”
“Credit valuations are stretched but justified,” she added.
The Fed might have bought markets more time, but not without cost. If inflation proves sticky, the very cuts investors are cheering for today could prove detrimental.
Eventually, the bill for cheap money is due, and it may be sitting at the Fed’s doorstep.
