Bank of America's Hartnett: How to determine if a significant rate cut by the Federal Reserve is counterproductive?

Even before the announcement of the Federal Reserve interest rate decision, Michael Hartnett, Chief Strategist at Bank of America, issued a warning that a significant rate cut is likely to lead to a resurgence of inflation risk, and gold will be the best hedge against accelerating inflation in 2025. Looking at the market performance after the 50 basis point rate cut by the Fed on Wednesday, besides Bitcoin, gold is indeed one of the best-performing assets.

However, except for the 10-year U.S. Treasury bonds, almost all assets are rising, which is almost the opposite of the traditional performance of "safe-haven" assets in a relaxed financial environment. The last time the market fell after a 50 basis point rate cut by the Fed was during the outbreak of the financial crisis in October 2008.

Explaining the reasons for this exuberant rise, Hartnett stated in the latest Flow Show report "Cutting Rates by 50 Basis Points for Small Businesses" that when there is no panic (at least not yet), Wall Street loves "panic rate cuts" the most. At the same time, the Fed hopes to cut rates by 50 basis points so that real interest rates can decline from the highest levels of this century, preventing layoffs in the already recession-hit small business sector.

"Panic Rate Cut" or "Soft Rate Cut"?

After announcing the rate cut, Federal Reserve Chairman Powell mentioned "re-calibration" ten times at the monetary policy press conference, indicating that the Fed is adjusting its monetary policy stance to adapt to the current economic conditions. Hartnett pointed out that Wall Street's interpretation of this is that the Fed may be "ahead of the curve," expecting a total of 250 basis points rate cut by the end of 2025, which could lead to 25-30% growth in U.S. stock earnings per share (EPS).

However, Powell seemed somewhat ambiguous when explaining whether the Fed is "behind the curve." Note that the last time the Fed cut rates by 50 basis points in a situation with such a low credit spread was in January 1981, and the U.S. stock market reached its all-time high in April 1986.

Historical data shows that after the first rate cut by the Fed, inflows into money market funds typically continue for 9 months. However, the aggressive easing policies in 2009 and 2020 led to a sharp decline in funds, which could be a signal of market bubble risk. Recently, there has been a significant outflow of funds from global stock markets, especially U.S. stocks, while the bond market continues to attract inflows, particularly investment-grade bonds and high-yield bonds. The report shows that the Federal Reserve has conducted 12 rounds of interest rate cuts since 1970. Based on the first interest rate cut and market reactions, they can be divided into three categories:

"Soft Landing Rate Cut": After the Federal Reserve cuts interest rates, the U.S. enters a "soft landing," such as in 1984, 1995, 2019... which is beneficial for stocks and bonds. The S&P 500 index rises by 10% within 6 months after the first interest rate cut, and the yield on 10-year U.S. Treasury bonds drops by 56 basis points.

"Hard Landing Rate Cut": After the Federal Reserve cuts interest rates, the U.S. enters a "hard landing," such as in 1973, 1974, 1980, 1981, 1989, 2001, 2007; which is unfavorable for stocks. The S&P 500 index falls by 6% within 3 months, but is beneficial for bonds as the yield on 10-year U.S. Treasury bonds drops by 38 basis points within 6 months.

"Panic Rate Cut": The Federal Reserve cuts interest rates due to Wall Street crashes/credit events, such as in 1987 and 1998... This is very risky, and the S&P 500 index rises by 20% within 6 months after the first interest rate cut.

Hartnett believes that the current market's response to a 50 basis point interest rate cut by the Federal Reserve seems to be following the script of a "soft landing rate cut" or a "panic rate cut."

In anticipation that the Federal Reserve can prevent the number of new job additions from falling below 100,000 and default rates from rising, Wall Street has engaged in a classic "Fed pivot" trade. For example, the asset boom from 9% to 4% interest rates by the Federal Reserve in 1975-1976 laid the foundation for the next more intense inflation surge.

Is the "Bubble Risk" Returning? Are Bonds and Gold the Best Hedge Tools?

Hartnett warns that currently, the U.S. stock and credit markets are digesting the expectation of a 250 basis point interest rate cut by the end of 2025 and a projected 18% earnings growth for S&P 500 index components. "The risks have not improved, so investors are forced to chase the uptrend," and the "bubble risk" is returning. It is advisable to buy bonds and gold on dips.

If new job additions remain between 125,000 and 175,000, this will indicate a "soft landing" for the U.S. According to Hartnett, stocks and commodities outside the U.S. are better investment targets, with the latter being a common hedge against inflation.

Finally, here are the best market "indicators" that Hartnett uses to determine whether a hard landing, soft landing, or no landing is imminent:

Soft Landing: If the price of the Private Equity ETF (PSP) exceeds $70, this may indicate that the market expects a significant interest rate cut by the Federal Reserve to be beneficial for the macroeconomy

Soft Landing: If the prices of certain specific ETFs, such as SPDR S&P Global Natural Resources ETF (GNR), Regional Bank Index ETF (KRE), and Emerging Markets ETF (EEM) exceed $60 and $45 respectively, this may indicate that Wall Street's inflation expectations will spread to a broader economic sector, namely "Main Street".

Hard Landing: If the yield on 30-year US Treasury bonds remains below 3.75% even in the face of debt, deficits, political uncertainty, and inflation, this may indicate that the market expects the economy to enter a recession