Six rate cuts in search of a reason

By Atul Bhatia, CFA

If all goes as many expect next week, the Fed will kick off a monetary easing cycle that will lead to overnight borrowing costs just below three percent by the end of 2026, according to interest rate futures.

Although the press often presents it as a momentous decision, whether the Fed cuts in September, October, or December is trivial in the long run, in our view. We feel quite confident the U.S. economy will not collapse if rates are held constant next week, nor will a rate cut usher in a golden age of prosperity. We think most investors realise that in an economy as dynamic and robust as the U.S., a few basis points for a few months likely amount to noise.

Rather than timing, we think the real question is how the Fed is supposed to fix the suite of economic issues confronting the U.S. when all it has is a hammer and there is scarcely a nail in sight.

No labour of love

Let’s start with labour markets, the oft-cited reason the central bank needs to cut. We think it’s clear that labour demand has fallen dramatically over the past three months. That’s as evident in nonfarm payroll numbers as it is in private data sources such as the ADP and Institute for Supply Management employment surveys.

But even as hiring slows, it’s not clear to us how much lower overnight interest rates would help. Traditionally, rate cuts work by stimulating economic activity spurring companies to hire. One of the most important channels to spur growth is cash-out mortgage refinancing, but with nearly 60 percent of borrowers sitting with mortgages below five percent, that avenue is likely choked off for the foreseeable future.

More broadly, the fall in labour demand is occurring as economic growth continues at a brisk pace. U.S. GDP increased 3.3 percent on an annualised basis in Q2 2025. If that’s not sufficient to promote hiring, what level of growth would be required, and how could it be achieved in a non-inflationary way? With unit labour costs in the second quarter up 2.5 percent year over year, it’s hard to see how the Fed can spur growth and hiring without pushing the U.S. uncomfortably close to wage-driven price inflation.

Rather than a general lack of economic activity, we think the key labour market drivers are technological change and a mismatch between corporate hiring needs and the existing labour pool’s skills. Those long-term issues are unlikely to be fixed by the Fed easing overnight borrowing rates.

Not so restrictive policy

Even if labour markets are a weak justification, Fed accommodation could be useful if other areas of the economy are suffering from restrictive policy. Looking around, however, we struggle to find signs of that:

• Yield curve: The classic sign that policy is too tight is an inverted yield curve, where long-term rates are below short-term rates, driven by the idea that elevated Fed policy rates are choking off growth and risking a recession. While cash rates are relatively high, other measures of curve shape – such as the 30-year vs. two-year yield difference – hit multiyear highs last week. If anything, the yield curve is telling us that anticipated Fed cuts are going too deep and risking a resumption of inflation.
• Corporate borrowing costs: Credit spreads – the additional yield relative to Treasuries that companies pay to borrow – are near their lowest levels in decades, and there are numerous signs of borrowers having market power in deals, with private credit funds, collateralised loan obligation (CLO) issuers, and banks fighting to provide loans.
• Inflation hedges: Gold, U.S. equities, and home prices are all at or near their all-time highs. To us, that speaks to an environment where people are concerned about the value of the dollar eroding and the need to protect against higher future inflation. That’s hardly an indicator the Fed is making money too hard to get.

The bottom line here is that even if monetary policy is, in the abstract, a bit restrictive, in the real world, it’s simply not.

For us, the explanation is found in loose fiscal policy.

One can argue about the exact conversion rate between budget deficit growth and policy rate cuts, but we think there’s a solid case to be made that the current U.S. budget deficit is equivalent to between three and five rate cuts. The net result is that in the context of current fiscal policy, monetary policy looks close to appropriate and far from excessively restrictive.

Risk management

“No harm, no foul” doesn’t appear in economic texts, but it’s a valid principle in the real world. Even if rate cuts won’t do much, if they don’t bring any negatives, why not give them a shot?

Dollar devaluation is one likely result we see from an unnecessarily aggressive Fed rate-cut cycle. The greenback is already down 10 percent versus major counterparts this year, and we would expect rate cuts to provide additional headwinds.

Whether a devaluation is a feature or a bug is largely a function of perspective. For those who hold equities, real estate, and precious metals, there probably isn’t a large downside from excessively cheap money. These assets can act as a hedge against inflation and tend to benefit as the dollar weakens. Borrowers also tend to benefit from a low-rate, cheap-dollar environment, a point that is probably not lost on the U.S. Treasury, the world’s largest borrower.

The people paying for the party are creditors. Not only will they have reduced purchasing power for foreign goods, but devaluation will likely have a meaningful negative impact on relative portfolio performance. Folks who are holding bonds to make a downpayment on a home, for instance, will likely find their homebuying power appreciably diminished if the dollar’s value continues to erode.

The Fed can and – we believe – should play an important role in defending the interests of long-term creditors, which include both price and currency stability. In our view, an aggressive rate cut policy likely undermines those interests and could make it more difficult for the U.S. to sell long-term bonds at attractive prices in the future.

Stand, and hopefully deliver

We think a Fed cut next week is best framed as a missed opportunity. Rather than provide potentially ephemeral gains by adding monetary fuel to a deficit fire, we would prefer the central bank send a strong message to markets globally that there is an institutional player concerned with creditor outcomes and the value of long-term U.S. government securities. Unfortunately, our wait for such a signal looks likely to continue.

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