The Fed is widely expected to cut interest rates only once this year and only in the fourth quarter of 2024. On the surface, all looks very good. After all, the labor market is reasonably strong, while the inflation numbers have not reached the Federal Reserve's target of 2%. But unfortunately, higher rates are an additional burden for the economy and investors' portfolios. There is a risk that one rate cut might not be enough to support the economy. In this article, I will discuss how the decision to cut interest rates only once might impact your portfolio.

The Fed's news

The Fed's members seem to be rather cautious about the progress on inflation. The Fed's Bostic said that as things stand, he continues "to believe conditions will likely call for a cut in the federal funds rate in the fourth quarter of this year." He also explained that one reason to be "patient" with that rate cut is to bring inflation back to the 2% mark. His colleague, Mary Daly, is also cautiously optimistic about America's battle with inflation. She also emphasized the need for the Fed to remain data-dependent to make sure inflation is on a sustainable path toward the 2% goal. According to Daly, if inflation slows down more than forecast, the Fed would likely have to keep rates higher for longer.

That means that the Fed has more of a wait-and-see stance towards monetary easing, since its main target remains inflation.

US macroeconomic statistics

But what exactly is happening to the US economy and what key data is the Fed looking at?

First of all, the Fed's duty is to maintain price stability (deal with inflation, in other words); support the labor market, thus keeping the unemployment numbers low; and provide for adequate, long-term interest rates. During many of his press conferences, the Fed's Jerome Powell emphasized that inflation remains his top priority. Meanwhile, in May, inflation was higher than thought, and rates were expected to hold steady. Fortunately for all of us, the recently published statistics for May indicate that the price level has not risen much. The core personal consumption expenditures (PCE) price index increased just a seasonally adjusted 0.1% for the month and was up 2.6% compared to the same period a year ago. In May, the lowest annual rate was recorded since March 2021.

As you can see from the graph above, the Fed's preferred measure is relatively low but still above the 2% target. May was generally a good month in terms of inflation, including the closely watched CPI indicator.

The table above showing changes from the preceding month indicates that the consumer price index (CPI) change in May was 0%. This is particularly encouraging, given the previous readings of 0.3% for April, 0.4% for March and 0.4% for February. But it was the first such result in many months. However, the CPI figure for the 12-month period ending in May 2024 was 3.3%. The trend may be best friend for the US inflation statistics. However, it is still questionable whether the May result was a one-off. Although the PCE numbers have been decreasing for many months, the CPI trend is not so clear.

Moreover, even though the inflation data are encouraging, they are still above the 2% target. Then, we do not know if these improvements will continue in the near future.

Now let us see the labor market.

The unemployment rate is reasonably low. In fact, it is near the levels seen before the 2020 pandemic.

Unemployment rate

The non-farm payrolls seem to be quite stable as well. In fact, the May results were much better compared to the ones recorded in April this year.

Non-farm payrolls (in thousands)

So, it seems the Fed has no particular need to stimulate the economy.

US recession indicators

The Fed is likely to intervene sooner than 4Q 2024 only if there is a recession. But what indicators are there that allow people to understand that a recession is about to happen soon?

There are several of these indicators. Some of these are typically perceived as positive signs for the economy. But they suggest the economy is overheated, and the Fed is about to intervene to tighten monetary conditions further, thus provoking an economic crisis. These are typical signs that we are experiencing an economic boom—the stage of the economic cycle just before the recession.

So, a recession normally happens after the boom stage when inflation readings are high, the labor market is strong, economic growth is high, there are asset bubbles, and monetary conditions are tight. Also, a useful recession indicator is the yield curve's inversion.

As I have mentioned above, the employment numbers are high. Although the inflation readings are not at multi-year highs, they are still above the Fed's target of 2%.

As concerns the economic growth, it is the best to look at the manufacturing and non-manufacturing PMI data issued by ISM. These are also useful business activity indicators.

PMI data issued by the Institute for Supply Management offers quite a mixed picture. To start with, the manufacturing PMI suggests contraction of economic activity because it is 48. If there were growth, then the indicator would have been above 50.

ISM manufacturing PMI

As concerns ISM's non-manufacturing PMI, it is safely above 50 right now, which suggests growth, albeit not as high as in 2021.

ISM non-manufacturing PMI

Then comes the Treasury yield spread. It typically gets negative before every recession. That is something that is happening now. In fact, it has been negative for a while, which is quite worrying.

The table below shows periods when the yield spreads went negative. It also shows recession periods, marked in grey. As you can see, the yield curve's inversion is quite a reliable recession indicator.

Another useful recession indicator is Shiller's P/E. It is a valuation metric that compares the current market valuations to the 10-year average inflation-adjusted earnings. It allows to see if the stock market is overvalued compared to the average earnings the listed companies generate.

It seems that the P/E ratio right now is even higher than it was just before the Great Depression and a little bit lower compared to the Dot.com bubble period. In other words, the valuations are far too high, and the assets are too overvalued, which is risky.

We all know that monetary conditions are quite tight right now, which is a serious risk factor for the US economy.

Right now, the base interest rate is at 5.50%, the highest in more than a decade.

What do higher rates for longer mean?

Higher rates for longer mean a greater recession risk. That is because the borrowing costs are high. The consumption and business activity levels are therefore low. So, economic growth slows down or gets negative. However, tighter monetary conditions also allow the US economy to fight inflation, which is particularly harmful for consumers and savers. The Fed might still succeed in fighting inflation without making the economy experience a recession. So, a "soft landing" is also possible if the Fed does not hold rates too high for too long.

That is why there are two possible scenarios. The first is that the economy will enter a recession if rates stay high for too long. The second is that there will be a "soft landing" for the economy. The economic indicators show a mixed picture. First, the labor market is strong. Second, the inflation numbers improved but are still above the Fed's target of 2%. US manufacturing PMI is weak, while the non-manufacturing PMI numbers are reasonable. Some indicators suggest a recession is imminent, namely the monetary conditions are very tight, the asset prices (Shiller's P/E) are far too elevated, and the Treasury yield spread has been negative for a while.

Portfolio strategies

As an investor, I perceive that both a "soft landing" and a recession are possible scenarios for the US economy.

If you expect a recession sometime soon, then it would be the best to park your cash in gold and high-quality bonds and US Treasuries because they have historically performed best during recessions.

If you expect the US economy to do well, high-yield bonds, commodities and stocks of "risky" companies have shown better performance during fair days than conservative assets.

If you accept that both scenarios are quite possible (like I do), then combining two strategies might be the best. That means diversification is appropriate. In other words, it is best to buy Treasury bonds and gold, as well as some stocks and commodities like oil and copper that rely on economic prosperity.

Risks

The biggest risk is that it is very hard to predict what will happen to the economy in the future. No-one expected the COVID pandemic back in 2019. It was a perfect "black swan" event. Something similar might happen now. Alternatively, the Fed might soften its stance further, thanks to the May inflation statistics. So, the macroeconomic indicators might substantially improve, and the asset prices might rise further. In my opinion, it is best to be prepared for any scenario.

Conclusion

In my view, anything is possible, given the current macroeconomic indicators. These paint a mixed picture. On one side, the monetary conditions are tight, while some indicators suggest the economy is overheated, while other indicators, like falling inflation numbers, suggest the Fed's war against inflation will be over very soon. I personally remain cautious about the health of the US economy. I neither say "we are about to enter a recession", nor the economy will do great. That is why I would personally choose diversification for my portfolio.