US CPI and the Rate Cut Debate

The US Consumer Price Index (CPI) ticked up ever so slightly in February—to 3.2% y/y from 3.1%—and as usual, all anyone wanted to talk about was what it meant for the Fed and the potential for rate cuts. Would the uptick make a summertime cut less likely? Or would core (ex. food and energy) inflation’s slight easing from 3.9% y/y to 3.8% help the Fed look through the headline rate’s wee acceleration? Through all of it ran the common thread: the assumption that unless the Fed cuts rates, this rally and the US economy will fizzle. We disagree.

Look, we get it. For the most part, high rates aren’t fun. Many banks haven’t passed them on to depositors, but they have gladly factored them into loan rates. High mortgage rates froze the housing market, constraining existing home inventory by discouraging currently low-mortgage rate sellers from listing, and putting prices out of many buyers’ reach. Higher borrowing costs—and fears they would cause a recession—spurred businesses to cut back over the past two years, and those cutbacks included layoffs. People want relief.

But here is the thing: Through it all, the US economy kept growing. It overcame all those pressures, helping GDP even accelerate as last year progressed. Stocks overcame them, too, bouncing swiftly from a 2022 bear market that rate hikes helped fuel. The first several months of this bull market featured big returns as the Fed continued tightening at an aggressive pace. So if we accept that stocks and the economy have done quite fine with high rates, then we see no foundation for arguing rate cuts are necessary for continued growth and robust stock returns. Stocks have spent nearly a year and a half undercutting that narrative. Even if you think the expectation of rate cuts buoyed stocks, look now: Recent inflation readings have shifted those expectations further and further out, with a slower pace of cuts and more chatter bubbling up that no cuts are coming this year. Yet stocks are nonplussed, sitting near records as we type. 

What rate cuts might—might—do, in conjunction with the Fed’s continued reduction of its balance sheet, is re-steepen the yield curve. While GDP has grown throughout the yield curve’s inversion, lending has slowed, and businesses have had to rely more on bond markets and private credit. This has been a-ok for large, high-quality, growth-oriented companies that can leverage strong balance sheets to get reasonably priced funding in these markets (and for those who are so cash-rich they don’t need to borrow constantly). But it hasn’t been as kind to the smaller and typically value-oriented companies that rely more on bank lending. They have had to be more judicious.

If the yield curve were to steepen, then loan growth could broaden and reaccelerate, helping economically sensitive value stocks. This isn’t a for-sure thing, as it remains unclear how much lending’s slowdown had to do with the yield curve. Treasury rates are a reference for banks’ funding costs and loan rates, but as we mentioned earlier, banks didn’t pass on rate hikes to depositors, which helped keep their funding costs in check and preserved lending’s profitability as long rates rose. This is just something to watch at this point, but it is a factor that could cause value to lead if and when it happens.

Regardless, saying rate cuts might cause a leadership rotation is very different from saying stocks need them. Again, stocks have already proven they don’t. That people don’t see it is a sign plenty of skepticism remains in markets, a good indication stocks have far more wall of worry to climb.