Federal Reserve Impact on Markets

…It has begun. Over the last year, I have made the strongest possible case for the Fed to be proactive. Rates should have been cut this week – indeed, the rates should have been cut in January. We have seen this movie before. The Fed was very late to take inflation seriously in 2021. They brushed it off as “transitory”. However, it seemed obvious that inflation was surging. Real-time shelter inflation was increasing at a double-digit rate. Shelter has the largest weight in the CPI. Shelter operates with a lag. Hence, it was easy to forecast the surge. The Fed was forced to react after the damage was done. The same mistake has been repeated – despite many warnings. The recent CPI print was 3% year-over-year (YOY). Nearly two thirds of this print was driven by one component – shelter. Shelter inflation is reported at 5.2% YOY. This number is far from reality. For example, Apartmentlist.com rents are running -0.8% YOY - a full 6% below the official CPI number. Suppose we believe the real-time shelter inflation is 2%, not 5.2%. This means the real-time CPI would be 1.8%. If you believe shelter is 3%, then real-time CPI would be 2.2%. These numbers are well within the Fed’s target. The Fed prides itself on making data-driven decisions. However, it is unwise to make decisions based on stale data. The shelter inflation happened in the past. Keeping rates high will not impact what happened last year. It is always best to look at forward-looking indicators for policy decisions. ·      My yield curve indicator has been inverted for 20 months. It is 8 of 8 with no false signals since the 1960s. The maximum historic lead time has been 23 months (before the great recession). Ignore it at your own risk. ·      The Sahm Rule has been triggered. This indicator is not necessarily predictive because employment moves with the business cycle – but it is useful in telling us whether we are in a recession or not. We know that hiring has slowed and unemployment has risen – though the absolute rate is still relatively low. ·      Retail sales are highly correlated with personal consumption expenditures. Retail Sales are flat. Many do not realize that Retail Sales are not inflation adjusted. Taking inflation into account recent sales growth as well as YOY sales are negative. ·      There is considerable evidence that COVID-era savings have been drawn down. A recent release from Philadelphia Fed carried the headline: “Share of Delinquent Credit Card Balances Reaches Series High”. (The same report shows an alarming plunge in mortgage originations.) People are paying 20%+ interest on a card because their savings have run out. Indeed, if people are cutting back on fast-food expenditures, you know this is serious.  Drawing down the savings has fueled consumption expenditures over the past two years. That source of growth has ended. Now the Fed will have to play catch-up and cut by at least 50bp in September. Any recession is a self-inflicted wound. 

The Federal Reserve matched our expectations and reduced its policy rate by 50 basis points to a range of 4.75 to 5.00 percent. This was the right decision and demonstrates the Fed wants to get on-sides as the balance of risks shift. Turning to the next few months, here is what I believe is important. Powell is in control of the FOMC. He mentioned the core PCE nowcast during the blackout was a factor behind yesterday’s move and likely dragged a few of his colleagues (Barkin) across the 50bp finish line. The outcome of this meeting tells me that Powell’s threshold to do more is probably somewhat lower than his colleagues. This is one reason I am inclined to not put too much stock in what the dots show. Unemployment up to 4.4% likely implies some weak jobs and activity data between now and year-end. Powell won’t have it. The next fight will be picking up the pace to neutral. Another 50bp rate cut is a call option on the data deteriorating. A weak(ish) employment report, we get two between now and the next meeting, likely cements another 50bp rate cut. So, my baseline through year-end is another 75bps of cuts. Additionally, if inflation continues to run below two percent, which is a notable possibility over the remainder of year, I think it warrants a more rapid pacing of easing, irrespective of whether the activity data are slowing. All in all, I thought it was the right decision for the economy and my general sense is that if Powell does the right thing once, he is willing to do the right thing again. That’s good for markets and the economy. 

Recent equity rotations reflect a downgrade to the market’s outlook for economic growth, but the prospect of Fed easing has left the S&P 500 near its all-time high. Our economists forecast the Fed will cut by 25 bp for the first time next week and expect 200 bp of easing through 1Q 2026 (vs. market pricing of 260 bp). But the trajectory of growth is a more important driver for stocks than the speed of rate cuts. The offsetting valuation impact of higher bond yields and better growth expectations imply limited scope for P/E expansion. With multiples flat, EPS growth will lead the S&P 500 modestly higher. Our year-end 2024 S&P 500 price target remains 5600. Our rolled 6-month and 12-month price targets are 5700 and 6000.

July’s employment report from the Bureau of Labor Statistics should give the Fed the exclamation point they have been looking for to show that the economy is slowing enough to warrant a rate cut. Market expectations have shifted firmly to a 50-bps interest rate cut at the Fed’s meeting in mid-September, rather than a 25-bps cut which had been the prevailing view prior to this report. Now handwringing will ratchet higher as to whether the Fed is in the process of successfully orchestrating a soft landing or if they have waited too long to shift their monetary policy stance. Job growth slowed more than expected in July and gains in May and June were revised lower. The unemployment rate increased 20 bps during the month and is up 60 bps over the past six months – unemployment rate changes of 50 bps or more over a six-month period have typically corresponded with recessions (see accompanying chart). Wage growth also appears to have slowed over the past couple of months. Even allowing for some volatility in the monthly data, the three-month moving average in employment growth and unemployment show an undeniable softening. Unemployment insurance claims add further evidence to the slowing trend. Initial unemployment claims have ticked higher over the past three weeks and continuing claims are at their highest level since the fourth quarter of 2021. It is difficult to call current labor market conditions weak with the unemployment rate still at 4.3%, but job gains appear increasingly lackluster across major employment sectors and the loss of momentum is undeniable. Stock and bond market participants are reacting in a way that suggests increased recession fears. Earnings reports have only fueled these concerns. The 10-year Treasury rate has fallen materially below 4.0%. Mortgage rates have also been ticking lower, which is good news for prospective home buyers. Rate cuts appear to be on the way, but macroeconomic conditions are increasingly precarious and the Fed’s September meeting may start to feel like a lifetime away if more bad news unfolds. The week ahead is not a busy one from an economic news perspective, but ISM services, mortgage delinquency, Fed Senior Loan Office Survey, and jobless claims, among others will be interesting to watch for additional information on the economy’s trajectory. What indicators are you watching for?

✂️ HOW STOCKS RESPOND TO RATE CUTS ✂️ (it's not what you think) People like to paint rate cuts as this path to universally lower rates everywhere and a stock market boom. This isn't always the case. The market response to rate cuts depends on the context of the cut. Yes, technically, the stock market does well after a rate cut if you average out 12-month returns. The S&P 500 has risen an average of 11% in the 12 months following every rate cut since 1970. But if you look at Fed cuts rates during expansions that don't preclude a recession in the following 12 months, the S&P 500 has been up an average of 13% over those 12 months. These are celebration cuts. Growth gets a boost, the economy stays afloat, everybody is happy. However, when the Fed cuts rates during expansions and a recession does materialize, the S&P has dropped an average of 11% over the following 12 months. And historically, more often than not, this scenario has led to a nasty crash in prices. These are desperation cuts. Cuts that are needed because the economy's already in a bad spot. The chart below illustrates the differences in outcomes for different rate cut cycles (a little different, as we’re not technically starting a rate cut cycle right now). Same takeaway, though – every rate cut is built different, and we shouldn’t assume the path forward will be easy. The economy’s future path matters more than Fed policy. That’s why it’s a mistake to ignore mixed signals right now, especially when the job market is flailing. Invest, but don't get too carried away.

As we continue to dissect the complexities of the U.S. economy, one key aspect stands out: the ongoing asynchronous, almost 'two-speed economy' that we have been describing for some time. This dynamic sees some sectors, like the current technology giants as well as high-income households still thriving under higher interest rates; by comparison, others, particularly construction, trade, and levered entities, are feeling the pinch. Without question, this week’s GDP data for 4Q 2024 showcased these contrasting trends. We saw solid headline growth of +2.3%, driven by an outsized consumption uptick of +4.2%. Goods consumption soared by +6.6%, likely fueled by pre-buying ahead of impending tariffs, while services remained robust at +3.1%. Government spending also contributed positively with a growth of +2.5%. On the flip side, sectors sensitive to interest rates and global trade struggled, with net exports flat and non-residential construction down by -1%. Interestingly, inventory drawdowns shaved a hefty 90 basis points from our GDP figures, a trend we expect to reverse somewhat in 2025 (despite higher tariffs). Looking at the broader picture, we at KKR still view the U.S. economy through a 'glass half full' lens. The Fed's gradual approach to easing rates comes amid strong equity performance, solid GDP growth, and stable credit spreads. No doubt, tariffs matter and there are more details to come, but our best estimate remains that – on net – new tariffs will subtract a combined 40 basis points from U.S. GDP in 2025, which we still pencil in at 2.5% including tariff drags. Meanwhile, on the rates side, the Fed recently held rates steady at 4.375%, signaling a ‘pause’ to assess the early impacts of the new administration's policies on tariffs, immigration, and spending. Chair Powell highlighted that the Fed isn't in a rush to cut rates further, opting to wait for signs of cooler inflation or a softer labor market before making any moves. Our outlook suggests that core inflation will drop from 3.3% today to around 2.8% by the end of 2026, which should allow the Fed to cut rates twice this year and twice next year while keeping real rates around one percent. Embedded in our forecast is that tariffs boost inflation by 30 basis points in 2025. By comparison, current market pricing appears overly hawkish, and we see better relative value in the belly of the curve (around the 5–7-year point). So, bigger picture, we continue to think we are in a higher-for-longer environment at the long end, given persistent fiscal deficits and the ongoing regime change towards higher nominal GDP growth. Beyond inflation and rates, we expect the currency market to remain extremely volatile. We saw a similar pattern in 2018 under President Trump 1.0, and we see now reasons why the macro environment for currencies will be different under President Trump 2.0. Read more about the impact of tariffs on growth and inflation in our 2025 Outlook: https://go.kkr.com/4a2pcP7

Pondering the Fed's Next Move - let me jump to the conclusion: The Fed is unlikely to cut rates anytime soon and market expectations continues to be wrong. I expect the FOMC to delay policy easing until inflation data falls to its 2% target, or employment/economy show a marked decline. Economist and the financial markets have concluded that inflation is on a glidepath towards the Fed’s 2% target (CPI/PPI currently in the 3-4% range). If inflation declines to 2% in the coming year, it’s likely the result of lower demand, or slower GDP growth rates. It is remarkable that we could be talking about a 2% inflation path given the resilience of GDP and employment growth rates. The Federal Reserve’s economic models suggest that a neutral Fed Funds rate is one that is consistent with 2% inflation and full employment. If we arrive at this point, there will be no need to cut rates at all, a condition that the economic models will surely support. In other words, with growth and 2% inflation, current Fed Funds might just be necessary, negating a pivot to lower rates. The Fed will move slowly. Remember, these are the same policy folks who made significant output errors with respect to their inflation forecasting models, so they might be hesitant to lower rates too quickly, especially since employment and economic growth remains resilient. Fed policy makers are asking themselves this question: if we lower rates, will this policy action re-stimulate inflation and growth? If you were Powell, what would you do under these circumstances? Currently, inflation remains stubbornly above the Fed’s target, so I don’t expect the Fed to cut rates until we see material economic weakness which will likely not be confirmed prior to its June ’24 meeting. What makes this particularly tricky for the Fed is that after June, its subsequent meetings are July 31 and September 18, just prior to the U.S. Presidential Election. The Fed certainly does not want to be appear political by easing right prior to the November 5th election. If the Fed don’t move by June, might they wait until the November 7th meeting, which falls 2 days after the election? This game theory presents an interesting dynamic, and avoiding politics is precisely why Chairman Powell emphasizes that the Fed remains data dependent. Chairman Powell acknowledges the progress on inflation, but suggests restrictive monetary policy will be warranted, thus implying ‘Higher for Longer’. Chairman Powell: "Recent declines in measures of underlying inflation, stripped of food and energy prices, were welcome, but two months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably... Restrictive monetary policy will likely play an increasingly important role. Getting inflation sustainably back down to 2% is expected to require a period of below-trend economic growth as well as some softening in labor market conditions."

All eyes are on the Fed’s anticipated rate cut this month, the most significant event shaping market sentiment. We’ve been hearing a lot of concerns that rate cuts signal an economic slowdown and could turn into a negative event for the markets. But is that really the case? In fact, the impact of rate cuts is highly contextual. According to a recent report by the Franklin Templeton Institute, history shows that the effect of rate cuts varies greatly depending on the economic conditions at the time. 📉 𝐑𝐚𝐭𝐞 𝐂𝐮𝐭𝐬 𝐢𝐧 𝐑𝐞𝐜𝐞𝐬𝐬𝐢𝐨𝐧𝐬 𝐯𝐬. 𝐄𝐱𝐩𝐚𝐧𝐬𝐢𝐨𝐧𝐬: • 𝐑𝐞𝐜𝐞𝐬𝐬𝐢𝐨𝐧𝐚𝐫𝐲 𝐑𝐚𝐭𝐞 𝐂𝐮𝐭𝐬: During recessions, rate cuts can initially cause a dip in equity markets. In these periods, equities have historically seen short-term declines, with Treasuries often outperforming as a safe haven. It’s a defensive play, indicating the markets brace for further economic deterioration. • 𝐄𝐱𝐩𝐚𝐧𝐬𝐢𝐨𝐧𝐚𝐫𝐲 𝐑𝐚𝐭𝐞 𝐂𝐮𝐭𝐬: However, when rate cuts occur during economic expansions, the story is entirely different. The report shows that equities tend to rally significantly after rate cuts in expansions, with growth and small-cap stocks leading the way. Historically, the S&P 500, Nasdaq, and Russell indices have all performed exceptionally well following expansionary cuts, with minimal drawdowns. 📊 𝐊𝐞𝐲 𝐒𝐭𝐚𝐭𝐬: • During recessions, equities declined by an average of 4.96% in the first three months post-rate cut, but then rebounded over the next 6-12 months. • During expansions, equities often surged, with the Nasdaq gaining 25.33% over the year following the first rate cut, while the S&P 500 rose 16.66%. So the big question becomes: Has the recent rate hike cycle slowed growth enough to push us toward a recession, or do we still have room for economic expansion? This is the critical factor that will determine whether the upcoming rate cut will spark a bull run or trigger a market pullback. 📈 𝐖𝐡𝐚𝐭 𝐇𝐚𝐩𝐩𝐞𝐧𝐬 𝐍𝐞𝐱𝐭? Historically, during rate-cutting cycles, value stocks perform well initially, but growth stocks take over as the market gains momentum. That’s exactly what we’re seeing right now—growth stocks have been outperforming, a positive sign that the economy could still have room to grow. More than anything, what will truly define the trajectory of the markets is how well the Fed manages to navigate the “soft landing”—balancing the slowing inflation without stalling economic growth. This delicate balance will be crucial in determining whether the upcoming rate cut sparks growth or reinforces recession fears. #MarketInsights #RateCuts #Investing #FedPolicy #GrowthStocks #EconomicExpansion #StockMarket #Treasuries

This week might be one of the biggest “money news” of the year - and here’s what to watch if you run a business or just want to make smarter financial decisions. Because even though the year is almost over… the economy isn’t slowing down. And this week, a LOT is happening. Here’s your simple breakdown 👇 1. The BIG ONE: The Fed decision (Wed 2pm ET) If you’re not familiar with the power of the Fed over the whole economy, I break it down in my video. The Fed is widely expected to cut interest rates - but that’s not the most important part. Here’s what really matters: 1️⃣ Dissents: Some Fed members may push for a bigger cut (50bp) while others want no cut. That division shows how uncertain things really are. 2️⃣ Forward guidance: Look for wording like “extent and timing of future changes.” If they add this back in, it basically means: “We’re not slashing borrowing costs anytime soon.” 3️⃣ The Dot Plot: This is the Fed’s forecast for future rates. The 2026 dot likely stays around 3.4%, which is higher than what markets expect (3.05%). Translation? The Fed may think rates stay higher for longer than Wall Street does. 2. U.S. job market signals (Tues 10am ET) The JOLTs report shows how many job openings employers are posting. Why you should care: More openings = strong hiring market → spending stays high → more financial stability Fewer openings = weaker hiring market → people spend less → businesses feel it. 3. Worker pay & labor costs (Wed 8:30am ET) The Employment Cost Index gives a read on how fast wages and benefits are rising. Why it matters: If pay is rising fast, companies may raise prices. If pay growth slows, people may spend less. Double-edged sword 4. Producer inflation (Thurs 8:30am ET) The PPI report shows inflation from the business side - what companies pay to make things. Why to watch: If business costs rise, consumer prices often follow. BONUS: Earnings season mini-wave A few names to watch depending on your industry: • Retail & consumer: COST, LULU, OLLI, PLAY, CPB • Tech & AI: ADBE, ORCL, AVGO • Housing & home improvement: TOL, HD Important to see how companies are actually performing vs. expectations. And in the AI world… OpenAI is expected to announce a new reasoning model this week that it claims outperforms Gemini 3. Why it matters: The “AI race” is no longer about speed - it’s about accuracy, reasoning, and real-world usefulness. This could shift investment, partnerships, and tech roadmaps going into 2025. So what’s the real story this week? Two big themes: ⭐ What the Fed signals about borrowing costs & policy for 2026 ⭐ Where the AI narrative goes next (because AI is driving the economy and market right now) For business owners, leaders, and anyone making money decisions, these updates help you answer: - Will borrowing get cheaper or stay tight? - Will customers feel more confident or more cautious? - Will tech investments accelerate or pause? - Will prices stabilize or stay unpredictable?

Fed Rate Cut Impact When the Federal Reserve (Fed) cuts interest rates, the stock market typically experiences several notable effects. While the specific outcomes can vary based on the broader economic context and market conditions, the general trends are often observed as follows: Immediate Market Reactions 1. Positive Sentiment: A rate cut usually signals the Fed's intention to stimulate economic activity, which can boost investor confidence. 2. Increased Valuations: Lower interest rates mean that the present value of future earnings increases, as the discount rate applied in valuation models decreases. 3. Sectoral Impact: Financials: Banks and other financial institutions may face pressure on their profit margins. Real Estate: Lower rates can boost the real estate sector by making mortgages cheaper, thereby increasing housing demand and benefiting related stocks. Technology: Tech companies, often characterised by high growth potential and significant future earnings, tend to benefit. Medium to Long-Term Effects 1. Economic Growth: Sustained rate cuts aim to spur economic growth by making borrowing cheaper for consumers and businesses. 2. Inflation Expectations: If rate cuts succeed in boosting demand, inflation may rise. 3. Corporate Debt: Lower interest rates make it cheaper for companies to refinance existing debt and issue new debt. Historical Context and Examples 1. 2008 Financial Crisis: During the financial crisis, the Fed cut rates aggressively to near-zero levels. Initially, the stock market continued to decline due to severe economic uncertainty. However, as the economy began to stabilise, lower rates supported a significant recovery in stock prices, culminating in a prolonged bull market. 2. COVID-19 Pandemic: In early 2020, the Fed cut rates to near-zero in response to the economic impact of the COVID-19 pandemic. This action, combined with other stimulus measures, helped to stabilise the stock market after an initial sharp decline, leading to a robust recovery and new market highs later in the year. Caveats and Considerations 1. Market Expectations: The impact of a rate cut can be muted if it is already widely anticipated by the market. 2. Economic Context: If a rate cut is perceived as a response to deteriorating economic conditions, the positive impact on stocks might be limited. 3. Long-Term Rates: While the Fed controls short-term interest rates, long-term rates are influenced by market forces. In conclusion, while Fed rate cuts generally have a favourable impact on the stock market, the extent and duration of this impact depend on various factors, including investor sentiment, economic conditions, and the broader monetary policy environment. Investors should consider these dynamics and remain vigilant to the broader economic signals accompanying rate cuts. References Federal Reserve Historical Interest Rates Impact of Federal Reserve Rate Changes on Stock Market Economic Insights from Fed Actions