Fed_Rate_Cut_9.18.24_pre
00:00:00.000 | Hello, everybody. It's Sam from the Financial Samurai Podcast, where I try to help you achieve
00:00:12.800 | financial freedom sooner rather than later. The Federal Reserve has finally cut interest
00:00:18.840 | rates by 50 basis points, not 25 basis points, and this is the first rate cut since 2020.
00:00:26.440 | The new interest rate target is 4.75% to 5%, and the dot plot signals interest rates will
00:00:33.820 | be down to 4.25% to 4.5% by the end of 2024 and by another 100 basis points by the end
00:00:42.720 | of 2025. So, December 2025, we could see the Fed funds rate at 3.25% to 3.5%. This rate
00:00:53.120 | cut is significant, and there is a lot that this rate cut will do for your money. In the
00:00:59.440 | short run, we're talking cuts to credit card interest rates, auto loans. The Fed funds
00:01:04.640 | rate is the overnight bank lending rate. It's the shortest end of the yield curve. Mortgage
00:01:10.280 | rates have already come down about 1.5% to 2%. The 10-year bond yield has come down in
00:01:15.480 | anticipation of this rate cut. However, given that the Fed has signaled continuous cuts
00:01:21.440 | over the next 16, 18 months, we should expect mortgage rates on the long end, the 10-year
00:01:27.800 | bond yield, specifically, to fade down as well. It might fade down to 3% by this time
00:01:34.240 | next year.
00:01:35.240 | So, I want to first talk about what the Fed rate cut means for the real estate sector.
00:01:40.720 | I am bullish on the real estate sector because I think we are heading into a really Goldilocks
00:01:46.680 | type of scenario. There is pent up demand. Many, many people over the past couple of
00:01:52.160 | years since the Fed started raising rates and since mortgage rates started going up
00:01:56.160 | aggressively have been holding off on buying. One, because they can't afford to, and two,
00:02:01.840 | because they think or they thought that higher mortgage rates would depress housing prices.
00:02:07.280 | Well, housing prices have come down in areas where you can build a lot of supply. For example,
00:02:12.880 | Austin, Texas or Boise, Idaho, where prices are down 10 to 15% from the peak. But those
00:02:18.760 | prices went astronomical during the pandemic. So, it's just a normalization here.
00:02:24.520 | There is a structural undersupply of homes. We're talking millions of homes undersupply
00:02:29.140 | in this nation. And it's going to get worse because from 2022 to right now, 2024, builders
00:02:36.560 | weren't building because it cost too much to build. So, this is going to be a lag effect.
00:02:40.200 | There's going to be undersupply going forward over the next several years. I don't see how
00:02:44.920 | this problem is going to get fixed. Three, you've got declining mortgage rates now, right?
00:02:50.040 | They're about 1.5% off from the peak, maybe 2% off from the peak actually. And they're
00:02:54.840 | probably going lower. In addition, we're probably going to have a soft economic landing or maybe
00:03:00.400 | a mild recession. A 50 basis point cut is signifying that the Fed sees a slowdown in
00:03:08.080 | the economy, specifically in the labor market. And they wouldn't have done 50 if they didn't
00:03:13.720 | see a greater slowdown than expected. If it was 25, they'd be like, well, okay, not too
00:03:18.160 | bad. But 50, maybe they see a little bit more sense of urgency. But in a way, that can be
00:03:22.840 | good because that shows that the Fed doesn't want to be too far behind the curve.
00:03:28.400 | Another positive for real estate is record high stock market wealth, 5,600 plus on the
00:03:32.520 | S&P 500. The market has created a tremendous amount of wealth for listeners, for readers
00:03:38.840 | of Financial Samurai, for the 60 plus percent Americans who own homes and the 50, what,
00:03:45.080 | 5% of Americans who own stock. So when you have more wealth, you're going to spend it.
00:03:51.160 | And we're entering a multi-year Fed rate cut cycle, right? By this time next year, the
00:03:56.760 | Fed funds rate could be down another one and a half percentage points. Further, with rates
00:04:03.400 | coming down, I see a potential rotation of capital from public equities more to real
00:04:10.480 | estate, private real estate, residential real estate, commercial real estate. There are
00:04:15.040 | opportunities to be had specifically in the commercial office real estate market. A lot
00:04:20.820 | of bombed out prices trading at 40, 60% discounts to where they were first purchased before
00:04:26.560 | the pandemic began. And you are seeing, you are seeing investors make those investments
00:04:32.440 | right now. And I think over a 10-year period, it's going to turn out to be quite good for
00:04:37.560 | them. Now that the Fed has cut rates, I think a lot of people are going to start getting
00:04:42.360 | off the sideline. Retail buyers, people who don't follow personal finance sites or listen
00:04:47.800 | to personal finance podcasts, are thinking to themselves, well, the Fed cuts rate, that
00:04:52.000 | means mortgage rates are going down. However, we all know that the Fed doesn't control mortgage
00:04:57.760 | rates. They influence mortgage rates, but mortgage rates are controlled by the bond
00:05:02.720 | market. So the mortgage rates have already moved. But what I see happening now is millions
00:05:08.160 | and millions of people looking at the headlines, listening to podcasts, watching TV saying,
00:05:12.880 | oh, the Fed has cut rates, that means mortgage rates are coming down. It's now safer to come
00:05:18.040 | out and buy. And as a result, I think you're going to see an uptick in demand. But the
00:05:22.880 | one thing that's throttling home buying right now, especially during a cyclically slow period
00:05:28.460 | of the year, right, second half of the year, fourth quarter specifically, is the election
00:05:33.160 | on November 5th, 2024. People are waiting to figure out who's going to win the presidential
00:05:39.200 | election in America so they can better understand where they want to live, for example, or what
00:05:44.360 | type of policies the new president will try to implement and how that will affect real
00:05:49.660 | estate prices, depending on where you live. For example, the salt cap deduction of 10,000,
00:05:55.160 | maybe that gets eliminated by the next president. And if so, that might create a lot more interest
00:06:00.320 | in buying coastal city or more expensive city real estate. Just as an example. Another example
00:06:06.000 | is first time home buying subsidy credits, right? $25,000 free money. What does that
00:06:12.760 | mean? Well, that probably means there will be greater demand for first time homes. And
00:06:17.840 | that means prices for first time homes, lower cost homes might be going up faster than medium
00:06:24.440 | priced homes or higher priced homes. So as an investor, you probably want to invest in
00:06:29.600 | first time homes, which would actually make them even more expensive. So there's all these
00:06:35.880 | second knock effect consequences for government policies that we have to think about and that
00:06:40.800 | people investors are thinking about until they get greater clarity on who is president,
00:06:46.360 | the next president of the United States. Now, what does a Fed rate cut mean for the stock
00:06:50.820 | market? Well, as a stock market investor, you have to compare your potential returns
00:06:57.120 | to the risk free rate of return. The risk free rate of return is the 10 year bond yield
00:07:01.800 | usually and that is hovering around 3.7%. So that means you wouldn't invest in any risk
00:07:09.040 | asset unless it returned potentially greater than 3.7% because you can get that risk free.
00:07:17.120 | Now, in general, lower rates are good for stocks because that means the cost of capital
00:07:23.080 | is lower, which means companies can borrow and invest more in their businesses. They
00:07:28.400 | can acquire other businesses. It would be more economic activity with a lower hurdle
00:07:34.520 | rate, lower interest rate, lower opportunity cost. More capital will be willing to invest
00:07:40.320 | in stocks because the opportunity cost of investing in a risk free asset like a 10 year
00:07:46.320 | bond yield is lower. So in other words, let's say the 10 year bond yield was very high.
00:07:50.440 | Let's say it was at 50%. You wouldn't invest in anything else that wasn't going to return
00:07:57.120 | greater than 50% because 50% is huge just doing nothing and especially if let's say
00:08:01.360 | inflation was under 50%. So this is what stock investors are thinking now. Okay, we're modeling
00:08:08.120 | out a decline in the Fed funds rate, a potential decline in long term bond yields. So as a
00:08:13.400 | result, we want to look at other asset classes to potentially generate a greater return.
00:08:19.080 | The tricky scenario is if the Fed is behind the curve and a recession comes where there
00:08:25.500 | are two consecutive quarters of negative GDP growth and the unemployment rate surges from
00:08:31.160 | the low 4 percentage point to 5 plus percent in a matter of 6 to 12 months. If that were
00:08:37.600 | to occur, then I expect the stock market, specifically the S&P 500 to go down and we
00:08:43.600 | have precedence for this. In the 1990s, the Fed started cutting rates, stock market went
00:08:48.440 | down. In 2007, during the most bubblish year of my lifetime at least, the Fed also delivered
00:08:56.440 | a half point rate cut on September 18, 2007. And what transpired then was the global financial
00:09:04.680 | crisis, which was the most devastating downturn in our lifetimes. In hindsight, it was clear
00:09:11.440 | the Federal Reserve was behind the ball. They had let the housing market bubble to crazy
00:09:18.920 | amounts, crazy levels, the stock market was going crazy, a lot of speculation. And then
00:09:24.440 | they were too late to start cutting. And then by the time they started cutting, everything
00:09:28.840 | unraveled.
00:09:29.840 | Today, things are a little bit better. Actually, they're much better. The corporate balance
00:09:33.600 | sheets are much better. Personal balance sheets are much, much better. Just look at the charts
00:09:38.960 | on how much home equity there is, how much money is in money market funds, how much lower
00:09:45.600 | the gearing is for corporate balance sheets in terms of having less debt. Profitability
00:09:50.840 | is much higher. So I don't think the Fed is as behind as it was back then. It might be
00:09:56.280 | a little bit behind, which is okay, but it's nowhere near as behind as it was in late 2007.
00:10:03.320 | As a result, I think with a telegraphed declining interest rate environment over the next 16
00:10:10.360 | to 18 months, plus a slowdown in the economy, softer landing, I think equities can do okay.
00:10:17.480 | They are overvalued from a historical KPE ratio, something like 30%. But if earnings
00:10:25.840 | can continue to grow over the next 12 months, maybe this current P multiple is not as expensive
00:10:32.360 | as it will be in the future.
00:10:34.440 | On a relative basis, though, if I had, let's say $10 to invest, I would invest $6, $7 of
00:10:42.600 | that into real estate because we have this huge tailwind going on with lower rates. Look
00:10:47.280 | at the publicly traded ETFs and real estate ETFs, as well as real estate companies like
00:10:53.040 | Redfin and Zillow. Those stocks are on fire. They are very forward-looking. They are quick
00:10:57.800 | to move, whereas residential real estate prices are slow to move, as well as private commercial
00:11:03.680 | real estate prices.
00:11:04.960 | Now for public stocks, I would still invest $2 or $3 of the $10 in the S&P 500 or your
00:11:11.960 | stocks of choice, because it's a low cost, easy way to gain exposure to the US economy,
00:11:19.200 | which is still growing. Despite elevated valuations, historically, the S&P 500 has returned about
00:11:24.600 | 10% a year. Now, maybe the future returns might be lower. 7.8% is what JP Morgan predicts
00:11:31.640 | over the next 20 years. And I know they're going to change their forecast next year.
00:11:36.000 | Vanguard is even more bearish. They're looking at like 4% to 5% annual returns over the next
00:11:42.480 | 10 years for the S&P 500 US equities specifically. So that's something to consider. However,
00:11:49.280 | again, investing in stocks have traditionally shown to be one of the biggest and best wealth
00:11:54.760 | creators over the long term at a low cost, and it's very easy to do.
00:11:59.600 | And then finally, I would invest the remaining $1 or $2 in private growth companies, specifically
00:12:05.840 | venture capital in the AI space. I'm here in San Francisco. I can't escape AI. I'm going
00:12:12.560 | to an AI party tonight. It's just everywhere. And we are seeing real use cases for AI as
00:12:18.400 | apps and software and products are being built. So by investing 10% to 20% of new cash flow
00:12:25.120 | or your existing portfolio in private growth companies, I think you have a good hedge.
00:12:31.320 | You have a hedge just in case these companies do extremely well in the future. You hear
00:12:35.600 | open AI trying to raise something like $6 billion plus at $150 billion valuation at
00:12:43.200 | the end of 2024, when they just raised at an $80 billion valuation in February 2024.
00:12:49.920 | So that's a huge gain in just 6 to 10 months. And I don't want to miss out on that. So I'm
00:12:56.320 | willing to allocate 10% to 20% of cash flow or existing capital to AI. If AI does great,
00:13:04.480 | this capital will do great. If AI turns out to be an overhyped bust, well, the capital
00:13:10.880 | will underperform probably the S&P 500. But at least our children will still have jobs
00:13:16.600 | and have purpose and meaning as AI doesn't take over their lives.
00:13:21.120 | All right, we've talked about how the Fed funds rate will affect borrowing costs, real
00:13:26.520 | estate and stocks. Let's talk about how the Fed funds cuts will affect your safe retirement
00:13:33.080 | withdrawal rate. Back in 2020, during the height of COVID, I introduced the Financial
00:13:39.640 | Samurai Dynamic Safe Retirement Withdrawal Rate. And that equals 80% of whatever the
00:13:47.520 | 10-year bond yield is at the time. And I came up with that because I look back in the 1990s
00:13:54.400 | when the 4% rule was created, and it was created when the 10-year bond yield was between 5
00:14:02.080 | to 6%. So 4% is 80% of 5 to 6%. So I went with that and I went with that logic. It's
00:14:09.240 | an easy way to think about how to withdraw money when you no longer have a day job. Now,
00:14:16.360 | when I introduced this, the 10-year bond yield was at about 0.6% because so much capital
00:14:22.200 | was fleeing stocks, fleeing real estate at the time to the safety of Treasury bonds,
00:14:29.600 | sovereign bonds by the United States government. If the world was going to hell and the virus
00:14:34.920 | was going to eat up and take over and kill everybody, at least we had the safety of Treasury
00:14:39.680 | bonds. So as bond prices went up, yields went down. And when I talk about 80% of the 10-year
00:14:46.600 | bond yield, that means having a safe retirement withdrawal rate of 0.5% because 0.65% times
00:14:56.080 | 80% is about 0.5%. And when I talked about this, a bunch of people on the internet went
00:15:03.880 | apoplectic saying, "This is a ridiculous assumption. 0.5% is way too low. That would
00:15:11.700 | require 200 times my annual expenses for me to retire early. Screw you. This is ridiculous.
00:15:18.800 | You're a chump." Whatever it is. And a lot of bad words. It's actually quite interesting
00:15:22.080 | how much fire there was. But you have to remember, this is a dynamic safe withdrawal rate. It
00:15:29.320 | changes as conditions change, economic conditions change, pandemic, vaccine, whatever. People
00:15:35.760 | move on with their lives change. It changes. And what I failed to understand was that people
00:15:41.480 | are stuck in this static mindset. They say, "Oh, 4% roll. Inverse that. 25 times your
00:15:46.080 | annual expenses, boom, you can retire with that net worth." But the thing is that is
00:15:51.560 | lazy thinking. That's easy thinking because you're like, "Okay, 4% roll. It is what it
00:15:55.880 | is." But if you stick with a 4% roll from 40 years ago, when the world is changing,
00:16:02.400 | you could get blown up. You could get left behind. And I don't want you all to get left
00:16:08.160 | behind. I want you to make more money than the median person or the average person so
00:16:14.120 | you can live a more free life sooner rather than later. So, if you adopted my dynamic
00:16:19.840 | safe withdrawal rate, then what you did was you lowered it to 0.5% during the worst of
00:16:25.040 | the pandemic. Instead of 4%, you're at 0.5%. And guess what? You had more capital. You
00:16:32.020 | had more safety to protect yourself against the unknown. And if you were so courageous
00:16:38.120 | and daring, you could have used that spread, 4% minus 0.5% or 3.5%, and used that extra
00:16:45.080 | capital to invest in risk assets like stocks, real estate, or whatever at depressed prices.
00:16:52.720 | And guess what, folks? Four and a half years later, you are much wealthier because of it.
00:16:58.880 | And not only did you invest more wisely, calmly, and diligently, your mental health was probably
00:17:04.920 | better at that time because you followed a dynamic framework that guided you during uncertain
00:17:10.600 | times. And as times got better, you could increase your safe withdrawal rate.
00:17:15.640 | Well, what's interesting to note is that just as the Fed starts its multi-year rate
00:17:21.680 | cut cycle, investment houses like JP Morgan, PGIMDC, which I've never heard of, and others
00:17:30.600 | are calling for an increase in the safe withdrawal rate from 4% to 5%. How is that logical? Let's
00:17:39.480 | think about it. If interest rates are coming down and the Fed is cutting rates because
00:17:44.840 | it fears a recession, that means there is more risk ahead. Slowdown, lose job, whatnot.
00:17:52.600 | There's risk there. Second, if interest rates are coming down, that means your risk-free
00:17:57.920 | rate of return is coming down. Therefore, you've got to take on more risk. And if you
00:18:04.600 | take on more risk, there's a greater chance you might lose money. You cannot, in a low
00:18:10.040 | interest rate environment, generate as much risk-free income to pay for your retirement.
00:18:14.000 | That was one of the benefits of higher rates. Savers were rewarded with five, five and a
00:18:18.760 | half percent risk-free money. That was amazing. That was enough to pay for life. But now,
00:18:24.800 | with rates going down, not so much. So why would you suggest increasing the safe withdrawal
00:18:30.840 | rate? But here's the other point of inconsistency from these investment houses. JP Morgan, for
00:18:37.520 | example, is expecting the next 20 years for public equities in the United States to return
00:18:43.120 | 7.8% per annum versus the historical 10% per annum return. Now that's 2.2% decline. While
00:18:50.720 | Vanguard is expecting 4% to 5% public equity returns for the next 10 years. And that's
00:18:58.280 | 5% to 6% below the historical rate of return of the S&P 500. So if you are expecting lower
00:19:06.800 | rates of equity returns and relatively stable to slightly lower bond yield returns, then
00:19:14.760 | it is completely counterintuitive and completely illogical to then suggest increasing your
00:19:21.040 | safe withdrawal rate in retirement. Even Bill Begum, the creator of the 4% rule in the mid-1990s,
00:19:28.920 | is also revising his recommended safe withdrawal rate up. He told Barron's that in his upcoming
00:19:34.840 | book he may endorse a rate very close to 5%. Now, I was trying to think why Bill would
00:19:41.280 | raise his recommended safe withdrawal rate by 25%, right, 4% to 5%. And I realized it's
00:19:49.540 | because he might be stuck in the past. He's writing a book. I've written books, right?
00:19:54.720 | Buy this, not that. How to engineer your layoff. It takes two plus years to write a book. The
00:19:58.960 | ideas you have when you first start writing a book and the ideas you have two years later
00:20:04.560 | can change. The world can change. Again, back to being dynamic in thought and in action.
00:20:10.920 | The dynamic safe withdrawal rate. Yes, 5% withdrawal rate made sense back in mid-2023
00:20:18.440 | when the 10-year bond yield was about 5% and long-term treasury bonds were yielding 5.5%.
00:20:24.400 | We talked about this before. Lock in some of that long-term treasury bond money at five
00:20:29.680 | plus percent. So good because I believed interest rates would eventually roll over. I've been
00:20:35.380 | believing that forever. Long-term interest rates are going to head down because of technology,
00:20:41.120 | efficiency, and better coordination among global economies. But today is different from
00:20:46.640 | yesterday. It's different from a year ago. The world changes and you cannot stick to
00:20:51.880 | ideas of the past if you want to keep up with people in the present, let alone wanting to
00:20:57.960 | outperform them. Being a retirement researcher is completely different than being an actual
00:21:03.380 | retiree with no active income, no steady paycheck, no retirement benefits, no subsidized health
00:21:09.060 | care benefits, nothing. You're on your own. Retiring is one of the most psychologically
00:21:14.480 | challenging transitions to face. You will not know how it feels like until you say goodbye
00:21:21.380 | to your job. Trust me on this, folks. I've been gone since 2012 and I struggled immensely
00:21:27.880 | during the first one to two years wondering, "Did I make a mistake? Did I blow myself up?
00:21:33.060 | Oh my gosh, what am I doing with my life? I'm screwed. What am I going to do?" But then
00:21:38.060 | over time, things change and then your expenses change. Your life changes. You might have
00:21:43.580 | children. You might want to buy a house. You might want to relocate. Something bad might
00:21:48.380 | happen. Things change all the time. Back to being dynamic and flexible with that change.
00:21:53.860 | Once you are retired, you don't have the luxury of pontificating about what retirement
00:21:58.700 | is like with numbers because you have real expenses to pay. You don't have a backup.
00:22:05.100 | And when you don't have a backup in the form of a day job or a wealthy spouse or a rich
00:22:10.340 | uncle or some kind of side hustle that brings in a lot of money, you have to be more precise
00:22:15.740 | in your analysis. Now, I know surveys have showed that 40-50% of retirees just wing it
00:22:21.820 | when it comes to their finances. Just like most people, I think, wing it when it comes
00:22:25.740 | to trying to build wealth. And then they wake up 10 years later and wonder, "Where did
00:22:29.740 | all my money go?" I suggest you not wing it. I suggest you follow a framework. You don't
00:22:36.540 | have to follow my framework if you don't believe in it, if you don't want to. But at least
00:22:40.660 | you should follow some type of framework to keep yourself honest so you consistently review
00:22:45.300 | your finances, you consistently save and invest for the future, and you consistently look
00:22:50.740 | at your asset allocation and compare it to your true risk tolerance and your goals.
00:22:55.620 | I'm excited over the next two years because the Fed is finally providing a tailwind for
00:23:00.460 | investors and for folks who want to work hard and make more money. Now, the Fed is not going
00:23:05.820 | to be great for savers, but rates are still relatively high and you still want to be disciplined
00:23:12.380 | in your saving and budgeting. But for those who want to work hard, who want to take more
00:23:17.260 | risks, who want to start companies, having this tailwind is a good thing. Just make sure
00:23:22.300 | you don't get out of hand by borrowing too much money.
00:23:25.780 | Thanks everyone for listening to the Financial Samurai podcast. Every episode takes hours
00:23:30.460 | to record, edit, and produce, so I'd appreciate a share and a positive review wherever you
00:23:35.700 | listen. Also, if you're looking for a professional second opinion about how you're investing
00:23:41.180 | your money, go to financialsamurai.com/advisorsor and speak to an Empower professional. He or
00:23:51.380 | she can go through what you're investing in right now and shed some blind spots that you
00:23:56.300 | might not realize. We're in a transition period. I'm hopeful about the future, but you never
00:24:01.820 | really know. And if you haven't had someone run through your investments in over a year,
00:24:07.700 | things can change, and it's good to have a free consultation. Check out the show notes
00:24:11.900 | for a direct link. And if you want to subscribe to the Financial Samurai newsletter, where
00:24:16.820 | 60,000 plus others have, go to financialsamurai.com/news. I'll talk to you all later.
00:24:23.180 | [Music]
00:24:28.180 | (dramatic music)