Cash will look increasingly unattractive over the next two years as interest rates fall, now that the US Federal Reserve (Fed) has turned a chapter in its playbook with a larger-than-expected interest rate cut at its September policy meeting. Following its first rate cut in four years, the upcoming chapters in the book should help to lift risk appetite and investment markets, as the central bank continues to cut rates progressively over the next two years.

Hence, the case to make idle cash work harder by seeking investment opportunities has become stronger now, as the Fed has started its rate-cutting cycle.

The Fed’s new rate cycle

The Fed surprised many at its September policy meeting by cutting its benchmark Fed funds rate by a large 50-basis points (bps). The move was to support the weakening labour market, but it also signalled to investors that the central bank is prepared to act aggressively to support the economy, if needed.

Fed Chair Jerome Powell cautioned against assuming that big rate cuts would continue, but it is clear that the Fed will continue to cut rates over the next two years, even if the pace and quantum may not be certain at this juncture.

It is also clear that the US central bank will do whatever it takes to support the economy and labour market, now that its battle against inflation seems largely over.

The Fed has room to cut rates sharply because it had hiked rates sharply between March 2022 and July 2023. Bear in mind that the Fed also has other significant tools in its arsenal that it has not used yet, and knowing this should offer comfort to investors who may be worried about a recession and a hard landing.

Here are five takeaways from the September Fed meeting:

1. The updated dot plot shows a gradual path of rate cuts going forward, suggesting that the Fed sees its aggressive 50 bps rate cut as a pre-emptive measure to stabilise the labour market, and not the start of a series of sharp rate cuts.
2. Projections after the meeting showed a narrow majority, 10 of 19 officials, favoured lowering rates by at least an additional half-point over their two remaining 2024 meetings. Seven policymakers supported another quarter-point rate reduction this year, while two opposed any further moves. So, Fed officials are not unanimous in their outlook for interest rates – which also supports the thesis that the US central bank may only cut rates gradually in 25 bps moves going forward, unless significant red flags about economy and job market start to appear.
3. The Fed’s updated dot plot shows that policy makers see the Fed fund rate at 4.4% at the end of this year, equivalent to a target range of 4.25% to 4.50%. This signals possibly two more rate cuts of 25 bps each at its policy meetings on November 6-7 and December 17-18. Policymakers pencilled in an additional percentage point of cuts in 2025, according to their median forecast. Through 2026, rates are expected to fall another half a percentage point to 2.9%. So, the Fed funds rate looks set to fall significantly over the next two years.
4. The Fed’s latest summary of economic projections show that policy makers see a soft landing (i.e. no recession) for the US economy. The updated quarterly economic forecasts, show the median projection for unemployment at the end of 2024 at 4.4%, only a small deterioration from the current level of 4.2%.
   
   In terms of economic growth, the median participant still sees real GDP growing at a solid pace of 2% this year and in the next three years. Powell said at the press conference after the meeting: “I don’t see anything in the economy right now that suggests that the likelihood of a recession, sorry, of a downturn, is elevated.”
   
   Meanwhile, the core PCE inflation rate (which is the Fed’s preferred inflation gauge) is expected to ease from 2.6% this year to 2.2% next year and 2% in 2026 i.e., the Fed does not see inflation as a problem going forward and sees it heading towards its 2% target – which will allow the US central to cut rates further.
5. In a sign of confidence about the economic outlook - the Fed said it will maintain the pace at which it’s reducing bond holdings every month. This means that the Fed is continuing with its Quantitative Tightening programme, and it is not panicking and does not see the need to do anything drastic to support the economy for now.

Bottomline

Market-friendly Fed rate cuts is not the best piece of news for those who are long on cash. However, it should augur well for investment markets. The Powell Put is in play and should support risk appetite. A supportive Fed and a resilient US economy provide a supportive backdrop for equities, bonds, and gold.

Bear in mind that it’s not just the Fed that’s cutting rates; other central banks are following suit. This should help to ease global financial conditions, prove counter-cyclical and support investment markets as well.

China’s strong package of stimulus measures announced recently, the most aggressive since the pandemic has also helped to ease concerns about the second largest world economy. The government has signalled more measures ahead and seems more determined that before to stem the country’s economic and property market woes.

History shows that equity markets tend to do well after the Fed embarks on rate cuts, provided a recession is averted and the US economy enjoys a soft landing. Rate cuts will also make US money market funds less attractive over time, causing a record amount (more than US$6 trillion) sitting in such funds to embrace riskier assets for better yields and returns. This could spell good news not just for Wall Street, but global markets too, as some of these funds will look to buy non-US assets as well.

In the short term however, investors may have to brace for a period of elevated volatility in the run-up to the US elections in November and given the geopolitical risks in the Middle East.

However, there is no reason to be too concerned as the medium-term trajectory for equities is still northbound. Volatility and corrections are normal in a bull market and do not alter the positive medium-term undercurrents.

In a nutshell, with returns on cash set to fall significantly over the next two years, it is important for investors with a decent risk appetite and who are long on cash to start re-examining their portfolios.