From: allin
The Federal Reserve recently cut interest rates by half a percentage point, bringing them down from a 23-year high [07:04]. This marks the first rate cut since March 2020 [07:11].
Rationale for the Rate Cut
Federal Reserve Chair Jerome Powell indicated that the Fed believes inflation is approaching the 2% target and they do not want the job market to soften further [07:17]. Powell also noted that immigration has contributed to softening the labor market [07:30]. Recent Consumer Price Index (CPI) data showed 2.9% in July and 2.5% in August [07:38]. Following the news, the Dow Jones Industrial Average surged 300 points to an all-time high [08:04]. Many anticipate more rate cuts at every upcoming meeting [07:58].
Historical Context of Rate Cuts
Since 1994, the Fed has initiated a cutting cycle six times [08:23].
- In 1995, 1998, and 2019, cuts began with 25 basis points [08:31].
- In 2001, 2007 (after the Great Financial Crisis), and March 2020 (due to COVID), cuts started with a 50 basis point reduction, indicating severe situations [08:33], [08:41], [08:49].
Past market performance following 50 basis point cuts:
- In 2001, the market fell 31% in the two years following the cut [08:54].
- In 2007, the market fell 26% after two years [09:01].
- In 2020, despite initial fears, the market increased by 44% over two years [09:06]. This 2020 outcome is seen as having a “big asterisk” as it was largely artificially created by a global shutdown and massive injections of money into the economy [09:18], [09:40].
Economic Implications and Outlook
Signs of Economic Tension
Rate cuts are generally a stimulatory move by the Federal Reserve, indicating tension in the economy, specifically between employment and unemployment, and between earnings growth and contraction [10:04], [10:17]. The expectation is for the Fed to continue cutting rates, potentially down to 2% or 3% by the end of 2026, to stimulate the economy again [10:23].
Historically, markets tend to fall once a rate cut cycle begins because the subsequent quarters often demonstrate the economic pressure the Fed anticipated [10:34]. While this pressure has not yet fully flowed through into earnings or company descriptions of market conditions (with a few exceptions) [10:49], if real pressure emerges, it will likely lead to a contraction in the value of financial assets as company earnings decrease [11:08].
Recession Concerns
The 50 basis point rate cuts in 2001 and 2007 occurred just before recessions, leading many to question if a recession is imminent now [11:25], [11:36]. While Powell’s comments suggest the economy is in “very good shape” and that inflation has been tamed [11:53], the magnitude of the cut (50 basis points instead of 25) is seen as unusual if the economy were truly “hot” [12:08], [12:25].
The market’s smart financial actors are betting that terminal rates will be dramatically lower than current levels within the next 18 months [12:46], [12:50]. This suggests they anticipate a recession or contraction, possibly alongside downward revisions to GDP data [13:18], [13:31].
The Yield Curve as an Indicator
The yield curve inverting (short-term interest rates rising above long-term rates) has historically been an almost perfect indicator of a coming recession [16:23], [16:29]. A recession typically occurs when the yield curve “de-inverts” [16:56], meaning the Fed sees economic weakness and cuts short rates [17:00]. The yield curve has recently de-inverted [17:20], raising concerns about whether a recession will follow or if the Fed can achieve a soft landing [17:24].
Labor Market Softening
The labor market has significantly changed from a period of high job availability (11-12 million jobs at peak) and difficulty finding talent [13:55]. Now, there is an abundance of viable candidates for positions, leading to concerns about the hollowing out of mid-paying jobs due to factors like increased immigration and outsourcing [14:33], [15:00].
In the tech sector, while conditions are not as “absurdly frothy” as during the 2020-2021 bubble, they remain good, driven by an “AI Tailwind” [15:46]. However, outside of AI, valuations and company operations have returned to more normal levels [16:04].
Venture Capital and Liquidity
The Venture Capital (VC) industry is experiencing a tough period, with fund managers struggling to generate liquidity [48:58], [49:47]. The typical duration for companies to return money has extended from 5-7 years to 11-13 years or more [50:11], [50:48]. Many funds, especially from the 2018 vintage, have yet to make a single distribution [48:11].
The industry was flooded with capital in 2020 and 2021 due to the federal government’s injection of $10 trillion in liquidity in response to COVID [55:31]. This led to larger funding rounds and inflated valuations, significantly impacting returns [55:58], [56:02]. The average Venture Fund’s expected 2x return was eroded as entry prices artificially doubled [56:10], [56:15]. The high number of startups entering the same verticals also spread out talent, earnings, and customer bases, leading to reduced ownership stakes for VCs due to higher valuations [57:42], [57:46], [58:04], [58:07].
The venture industry is now working through this “hangover” [56:21]. The good news is that the rise of AI represents a highly exciting technological wave, comparable to the internet’s emergence in the mid-to-late 1990s [56:39], [56:44]. This new wave could lead to another “Golden Era” for venture capital, especially if interest rate cuts continue and inflation remains tamed [01:06:46].
Despite these challenges, the decline in the percentage of first-time VC managers raising a second fund (from over 50% to below 15%) suggests a market correction [48:47], [59:17]. This may lead to less capital being raised, potentially foreshadowing that new companies will require significantly less capital [59:28], [59:30]. The IPO process and the ability for companies to access public market capital are considered fundamentally broken, requiring reinvention [00:59:51], [01:00:04].