Weak Economic Data Supports 3 Fed Rate Cuts this Year

The US economy is weakening and will enter a recession if the Fed does not cut interest rates significantly this year.  GDP data released last week show that growth has only averaged 1.5% this year and the interest sensitive construction and residential sectors have contracted over the last year in response to tight Fed policy.  In addition, employment growth has stalled with less than 35k jobs created on average over the last 3 months according to the recent employer survey and over 850k jobs lost according to the household survey.  Continuing claims also remain elevated at almost 2MM.

We believe the only reason the US economy is not in recession is the housing sector has become less cyclical as home building has remained muted since the GFC with only an average of 1.1MM homes started with a peak of 1.8MM.  During the 10 years prior to the GFC starts averaged 1.7MM with a peak of 2.3MM.  Consequently, there is a significant shortage of homes in the US of approximately 4MM homes.  Also, there is now an active group of investors buying new homes to rent out which provides for more resilient demand than existed in the past.  A decline in the housing sector accounted for 12 out of 13 post WWII recessions.  The only reason we are not in a mild recession already is that tech investment is booming with the capital-intensive nature of AI driving an unprecedented level of capital expenditures.

Inflation is well contained as the shelter component of CPI is delayed by 2-years.  We publish real time inflation data (CPI-R and PCE-R) that show inflation is at or below the Fed’s target with CPI-R at 1.1% and PCE-R at 2%.  Inflation is caused by excessive monetary growth and to a lesser degree by oil price shocks.  The money supply has shrunk by almost 10% over the last year and oil prices are down 8% since the beginning of the year which indicates that inflation is likely to continue to decline.  Tariffs affect less than 5% of CPI and any increase should be treated as a one-time tax for the purposes of formulating monetary policy.

Long term interest rates are 65% correlated to the expected terminal rate of the Fed Funds rate with the normal spread being 100bp or 1% over the 10-year treasury.  Right now, the expected terminal rate is 3.21% and the 10-year is at 4.21%.  As the Fed makes it clearer that they will be forced to cut rates this year, despite its unfounded fears that tariffs will cause inflation to spiral out of control, we forecast the expected terminal rate to drop below 4% and the 10-year to end the year in the 3.5-4.0% range.

The decline in both the Fed Funds rate and the 10-year treasury rate is a big tail wind for both preferred stocks and high yield bonds.  We believe investors can add to those asset classes as we head into the volatile Fall period.