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Fed vs Stocks: Finding the sweet spot

Opinion has been extremely divided about the recent Fed rate cut. Some say it was necessary and prudent, others say it wasn't needed, and there are even those who say they're doing too little to late and rates are on their way to zero.

But that's only one arena of dissent.

The bigger issue arguably is what it means for markets and the outlook. And in that arena there are likewise multiple opposing views facing off. Some might say it's a red herring, others a sign of a bear market, and others yet that it's going to extend the bull market.

In the following I attempt to address and add clarity to these issues with the cold truth of charts and indicators. I'll certainly let you know what I think, but in the end the charts will to a certain extent speak for themselves...

The "Sweet Spot Indicator" and the S&P500: this weird indicator is one of my own - it takes the Fed funds rate and uses wage growth to basically contextualize it. It allows a simple model whereby we can form a judgement as to whether the current interest rate level is "good for stocks" or not.

Why though? Firstly the rule of thumb is: the greater the spread between wage growth and the Fed funds rate, the better it is for equities (and the lower the spread, particularly when it goes negative, the worse it is for equities).

The economic logic is: higher wage growth is good for stocks because it means greater discretionary income and savings (funds that can be invested) and greater confidence (and thus willingness to take risks and deploy optimism). Meanwhile lower interest rates tend to be stimulatory for the economy (make borrowing and capex cheaper/more attractive), and tend to increase the opportunity cost of holding cash vs riskier yet higher expected return assets like stocks. So the indicator captures the signal from both of those angles, and it stands to reason that a higher rate of wage growth relative to the Fed funds rate reflects more of that good stuff in action.

The components: specifically, what I have used is the Fed funds target rate and the Atlanta Fed wage growth tracker. The chart below shows the evolution of the two series. Most readers by now will probably realize that for rate cuts to be bullish for stocks, wage growth will need to hold up and/or accelerate (i.e. *not collapse*).

In fairness, that is an area of fundamental uncertainty. But I will say that my indicators show the US labor market is still running with very tight capacity, so while wage growth is obviously going to slowdown if the economy rolls over, it's fair to say there is upside risk to wage growth if a positive or even benign economic growth environment prevails.

What were you expecting?

So what's up with the rate cut anyway? Here is where we start looking at the controversy and combat around the reasons and sensibility of the rate cut. It was a clear and distinct pivot from the path they were on and the path most people thought they were on. But I have a couple of charts which I think will add some robust fodder for thought.

Fed cuts rates

Why did the Fed cut rates anyway?

As I mentioned, there are still plenty of signs the US economy is doing alright, and indeed, the second chart in this article shows plainly that wage growth looks solid. I'm going to mostly leave the politics out of this (but then in this environment we can't completely ignore them either!).

To me this chart says it all. The global manufacturing PMI *excluding the US* has fallen -7.5pts since the peak in December last year; well into contractionary territory. And while the US PMI has not quite crossed over to contraction, it has clearly been caught in the global economic downdrafts.

global shock to US economy

In short, the US economy faces headwinds and downside risks from a weaker rest-of-world outlook.