The Federal Reserve Mistake Index is telling the Federal Reserve to cut interest rates. The effective Federal Funds rate is 5.3%, 49 basis points above the 2-year US Treasury yield of 4.8%.
The 2-year US Treasury yield is a great predictor of future Fed policy. It is likely that the Fed will cut rates next year. The stock market is cheering this eventuality as the S&P 500 continues to rally in November to retrace most of its fall since the Fed embarked on its Fed hiking cycle in Q1 of 2022.
Studying modern history gives us reason for pause. After breaching a reading of 100 basis points on the Fed Mistake Index in 2001 and 2008 the Fed quickly cut rates in an attempt to forestall recession. In both instances market forecasters predicted this would be a boon to the stock market. Recessions and market crashes soon followed.
If any market stands to behave differently this time, it is the post Covid market we are in today. So far, the economy has defied expectations and remained strong. But it is always a dangerous bet to ignore history. We may seamlessly transition from 12 years of zero percent interest rates, vanquish the first inflation in over 40 years, and the Fed may finally nail the elusive soft landing. But just in case the future ends up resembling the past, investors should continue to keep some safe bonds earning 5% in their portfolio and outside of a vulnerable S&P 500.