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A CUT — AND THEN WHAT?

The Federal Reserve is set to cut U.S. interest rates for the first time since
the pandemic. History shows the state of the economy will play a crucial role in
how markets respond.

By Lewis Krauskopf, Prinz Magtulis, Pasit Kongkunakornkul and Vineet Sachdev
Published Sept. 17, 2024  10:30 MESZ

How stocks, bonds and the dollar perform after the Federal Reserve kicks off its
rate-cutting cycle could depend on one factor more than most: the health of the
U.S. economy.

The Federal Reserve is expected to kick off a series of rate cuts on Wednesday,
after raising borrowing costs to their highest level in nearly two decades.
Markets are pricing in roughly 250 basis points of easing by the end of 2025,
LSEG data showed.

For investors, a key question may be whether the Fed will cut rates in time to
avert a potential economic slowdown.


CUTTING TIME

The Fed is expected to kick off a rate-cutting cycle to bring down borrowing
costs from their highest levels in more than two decades.

20%

Recessions

15

10

5.5%

5

0

1971

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

2024

Line chart of the monthly federal funds target rate level from 1971 to 2024.

Data plotted is the top end of the federal funds target range.

Sources: Reuters research, LSEG Datastream

The S&P 500 has slumped an average of 4% in the six months following the first
reduction of a rate-cutting cycle, if the economy was in a recession, data from
Evercore ISI going back to 1970 showed. That compares to a 14% gain for the S&P
500 when the Fed cut in a non-recessionary period. The index is up 18% in 2024.

“If the economy is falling into recession, the rate cuts aren’t enough of a
support to offset the move down in corporate profits and the high degree of
uncertainty and lack of confidence,” said Keith Lerner, co-chief investment
officer at Truist Advisory Services.

Treasuries have performed better during recessions, as investors seek the safety
of U.S. government bonds. The dollar, meanwhile, tends to rise less during a
downturn, though its performance could depend on how the U.S. economy fares in
comparison with others.




STOCKS

Recessions are typically called in hindsight by the National Bureau of Economic
Research and for now, economists see little evidence that the U.S. is currently
experiencing one.

Those conditions bode well for the rally in U.S. stocks, should they persist.

“Based on previous easing cycles, our expectation for aggressive rate cuts and
no recession would be consistent with strong returns from U.S. equities,” said
James Reilly, senior market analyst at Capital Economics, in a report.

Still, worries over the economy have jolted asset prices in recent weeks.

Weakness in the U.S. labor market has helped fuel sharp swings in the S&P 500,
while global growth concerns are reflected in slumping commodity prices, with
Brent crude oil trading near its lowest level since late 2021.

Uncertainty over whether growth is merely falling back to its long-term trend or
showing signs of a more serious slowdown are reflected in futures markets, which
in recent days have swung between pricing in a 25- or 50-basis-point cut on
Wednesday.


THE RECESSION FACTOR

Stocks perform better when rate cuts are not accompanied by a recession.

Change in S&P 500

-20%

-10%

-5%

0%

+15%

-15%

+5%

+10%

+20%

First rate cut of a cycle

1 month

after initial cut

Normalization

3 months

6 months

12 months

June 1989

July 1995

July 2019

Stocks have tended to rise after “normalization” cuts. The same holds true for
cuts during “panic” situations, such as the 1987 crash.

‘Panic’

Oct. 1987

Sep. 1998

March 2020

Cuts during a recession are followed by lower stock prices, however.

Recession

July 1990

Jan. 2001

Sep. 2007

A heatmap of average percentage change in the S&P 500 during select start dates
of a rate-cut cycle by the Federal Reserve. The dates of first cuts are
categorized whether the cut was made to normalize a high-interest-rate regime
(“normalization”), was made during a U.S. “recession”, or was done during a
“panic” scenario.

Source: Carson Investment Research

The state of the economy is important for investors looking to gauge stock
performance over the longer term, as well. The S&P 500 was down an average of
nearly 12% one year after an initial cut that took place during a recession,
according to a study by Ryan Detrick, chief market strategist at Carson Group.

That compares to an average gain of 13% following cuts that came in a
non-recessionary period, when the reductions were to “normalize” policy,
according to the data, which studies the last 10 easing cycles.

“The linchpin to the whole thing is that the economy avoids recession,” said
Michael Arone, chief investment strategist for State Street Global Advisors.


BEFORE AND AFTER

Stocks have typically dipped going into a rate cut and risen in the months that
followed.

Absolute returns

-4%

0%

+4%

+8%

+12%

Fed rate cut

12 months

after rate cut

12 months

before rate cut

1 month

1 month

3 months

3 months

6 months

6 months

Healthcare

Consumer staples

Communication services

Energy

The S&P 500 on average declines few months leading up to a rate cut...

Technology

Russell 2000

S&P 500

...but bounces back about six to 12 months after.

Utilities

Industrials

Consumer discretionary

Financials

Materials

Real estate

A heatmap showing the average percentage change in performance of S&P 500 and
its sub-sector indices from a year before the Federal Reserve cuts rates to a
year after.

Source: Evercore ISI Research

Overall, the S&P 500 has been 6.6% higher a year after the first rate cut of a
cycle — about a percentage point less than its annual average since 1970,
Evercore’s data found.

Among S&P 500 sectors, consumer staples and consumer discretionary had the best
average performance, both rising around 14% a year after the cut, while
healthcare rose roughly 12% and technology gained nearly 8%, according to
Evercore.

Small caps, seen as highly sensitive to signs of an economic turnaround, also
outperformed, with the Russell 2000 rising 7.4% over the next year.




TREASURIES

Bonds have been a rewarding bet for investors at the start of rate-cutting
cycles. This time around, however, Treasuries have already seen a huge rally,
and some investors believe they are unlikely to run much further unless the
economy experiences a recession.

Treasury yields, which move inversely to bond prices, tend to fall alongside
rates when the Fed eases monetary policy. The safe-haven reputation of U.S.
government bonds also makes them a popular destination during economic
uncertainty. The Bloomberg U.S. Treasury Index returned 6.9% on a median basis
12 months after the first cut, Citi strategists found, but 2.3% in
“soft-landing” economic scenarios.

The yield on the benchmark 10-year Treasury has fallen about 20 basis points
this year and stands near its lowest level since mid-2023.


DIP AND RISE

Yields for benchmark Treasuries have generally been higher a year after the
first cut. Yields move inversely to bond prices.

Change in 10-year U.S. Treasury yield

-100 bps

-80

-60

-40

-20

0

+20

+40

+60

+80

+100

+120 bps

First rate cut

of a cycle

1 week

after first cut

1 month

3 months

12 months

June 1989

July 1995

Sep. 1998

Jan. 2001

Sep. 2007

July 2019

March 2020

The 10-year yield has fallen a median of 9 basis points in the month following
the first cut...

...but climbed a median of 59 basis points a year after the initial cut.

A heatmap showing the change in 10-year U.S. Treasuries performance in basis
points during select dates of the start of a Federal Reserve rate cut cycle.

Source: CreditSights

Further gains in Treasuries may be less certain without a so-called economic
hard landing that forces the Fed to cut rates further than anticipated, said
Dirk Willer, Citi’s global head of macro and asset allocation strategy.

“If you get a hard landing, yes, there’s a lot of money on the table,” Willer
said. “If it’s a soft landing, it's really a bit unclear.”

That said, getting in early might be key. The 10-year Treasury yield has fallen
a median nine basis points in the month following the first cut in the last 10
rate-cutting cycles and climbed a median 59 basis points a year after the
initial cut as investors begin to price an economic recovery, data from
CreditSights showed.




DOLLAR

The U.S. economy and the actions of other central banks have been important
elements in determining how the dollar will react to a Fed easing cycle.

Recessions often require deeper cuts from the Fed, with falling rates eroding
the dollar’s attractiveness to yield-seeking investors.

The greenback strengthened a median 7.7% against a trade-weighted basket of
currencies a year after the first rate cut when the economy was not in a
recession, an analysis by Goldman Sachs of the prior 10 cutting cycles showed.
That compares to a 1.8% gain in the same time period when the U.S. was in a
downturn.

At the same time, the dollar tends to outperform other currencies when the U.S.
cuts alongside a number of central banks, according to a separate Goldman Sachs
analysis. Rate-cut cycles that see the Fed moving alongside relatively few major
banks, on the other hand, often result in weaker dollar performance.


DIVERGING DOLLAR

Median change in the U.S. dollar trade-weighted index during the past 10
rate-cut cycles

Fed rate cut

108

No recession

106

104

102

Stronger dollar

100

Weaker dollar

Recession

98

96

12 months

before rate cut

6 months

6 months

12 months

after rate cut

A line chart of the U.S. dollar trade-weighted index showing its median
performance before and after the past 10 rate-cut cycles of the Federal Reserve.

Source: Goldman Sachs Global Investment Research

The scenario of cutting alongside a number of other central banks appears to be
in play now, with the European Central Bank, the Bank of England and the Swiss
National Bank all cutting rates.

The U.S. dollar index, which measures the greenback's strength against a basket
of currencies, has weakened since late June but is still up about 9% over the
past three years.

“U.S. growth still stands out a little bit better than most countries,” said
Yung-Yu Ma, chief investment officer at BMO Wealth Management. “Even though the
dollar strengthened so much, we wouldn’t expect a meaningful degree of dollar
weakness.”

That could change if U.S. growth sputters, analysts at BNP Paribas wrote.

“We think the Fed would be likely to cut by more than other central banks in a
potential recession scenario this time around, further eroding the (dollar’s)
yield advantage and leaving the currency vulnerable,” they said.



Sources

Carson Investment Research, CreditSights, Evercore ISI Research, LSEG
Datastream, Goldman Sachs Investment Research

Edited by

Anand Katakam, Ira Iosebashvili and Rod Nickel


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