By Joseph Adinolfi
Investors care more about what Fed rate cuts say about the economy, history shows
A Federal Reserve interest-rate cut in September now looks like a virtual certainty. But how stocks might react to such a move remains as murky as ever.
In theory, lower interest rates should help boost stock prices, since lower rates typically translate to lower borrowing costs, which allow companies to keep more of the money they earn through sales, said Callie Cox, chief market strategist at Ritholtz Wealth Management. Rate cuts also boost the attractiveness of stocks compared with bonds by driving bond yields lower. Bond yields move inversely to bond prices.
See: Powell says time has come for rate cuts. Here's the opportunity for investors.
But history shows that stocks don't always climb after a first Fed rate cut. Sometimes, indexes like the S&P 500 are lower - even dramatically lower - three months or even a year later.
When it comes to how stocks might react this time around, the lesson is that ultimately, investors' feelings about the strength of the economy will outweigh their enthusiasm for lower borrowing costs, according to Cox and Kevin Gordon, a strategist at Charles Schwab. Put another way, it's not just whether the Fed is cutting rates that matters for stocks. The reason for cutting them is important, too.
"The economy really matters in terms of how markets respond to policy pivots," Cox said during an interview with MarketWatch.
"Is the Fed cutting interest rates out of celebration, or desperation?" she said. "If these are rate cuts out of celebration, then lower rates are really good for the stock market. But if the Fed has to swoop in out of desperation and cut rates, typically that's bad for stocks."
A Dow Jones analysis of how stocks have reacted to previous Fed cuts hinted at this divergence. According to Dow Jones Market Data, the Fed has embarked on five rate-cutting cycles since the early 1990s, when the Fed changed how it communicates policy shifts to the public by starting to announce changes to its target rate.
First rate cut S&P 500 +1 week +2 weeks +3 weeks +1 month +2 months +3 months +6 months +1 year 7/6/1995 2.49 0.68 2.62 2.13 4.00 6.46 12.69 20.13 9/29/1998 -5.73 -4.86 1.31 1.85 13.70 16.86 22.32 22.27 1/3/2001 1.37 3.38 6.01 5.16 -3.83 -10.71 -3.63 -10.02 9/18/2007 2.78 4.77 5.14 4.37 -1.21 -2.08 -13.55 -21.69 8/1/2019 -3.23 -4.69 -1.88 -1.81 -1.35 1.92 8.23 9.76 Average (%) -0.47 -0.14 2.64 2.34 2.26 2.49 5.21 4.09 Median (%) 1.37 0.68 2.62 2.13 -1.21 1.92 8.23 9.76
SOURCE: DOW JONES MARKET DATA, FACTSET, ST. LOUIS FED
On average, the S&P 500 was up 2.5% three months after the first cut. But that average belies rocky reactions to rate cuts in 2001 and 2007.
Three months after the central bank started cutting rates in 2001, the S&P 500 SPX was down 10.7%. And three months after the Fed cut rates in 2007, the index was off by 2.1%, according to Dow Jones Market Data. A year after both those cuts, the index had chalked up double-digit losses.
Looking even further back reveals more evidence that the first rate cut doesn't always bode well for stocks.
Data from Renaissance Macro showed that, since 1970, a lower Fed policy rate tended to coincide with an initial selloff in stocks, provided the market reaction to the Fed's most recent cutting cycle in 2019 is excluded.
Frothy valuations for large-cap stocks could make markets vulnerable to an adverse reaction this time around, especially as signs of a slowing economy and labor market could undermine Wall Street's lofty forecasts for earnings growth.
If stocks continue to climb between Monday and the first cut, it could tee up what some on Wall Street call a "buy the rumor, sell the news" reaction. Such a reaction occurs when stocks climb ahead of an anticipated event, only to sell off once it has passed.
Further muddying the waters is the notion that the central bank is preparing to cut rates during what has typically been the most volatile stretch of the year for stocks. September has been the worst month for stocks going back decades, according to Mark Hackett, chief of investment research at Nationwide.
Currently, stocks are poised for a soft landing for the U.S. economy, stock-market strategists said - meaning traders expect the Fed will succeed in lowering borrowing costs without sparking more weakness in the labor market.
But investors' perceptions about the state of the economy can change in an instant. Just look at how stocks reacted earlier this month, when a weak July employment report triggered a growth scare that bulldozed global markets.
Going forward, investors will be keeping a close eye on all incoming economic data, Schwab's Gordon said. But the August jobs report, due Sept. 6, will likely receive the lion's share of the attention.
More disappointing jobs data could swing traders' expectations toward a cut of 50 basis points. Fed Chair Jerome Powell was believed to have left the door open to a more dramatic cut during his speech at Jackson Hole, Wyo. on Friday when he said the Fed would do whatever was necessary to protect the labor market.
A more forceful start to the Fed's easing cycle could send a shiver through markets, Gordon said.
"There's a ton that could still go wrong. We're still skating on relatively thin ice," he said.
U.S. stocks finished mixed on Monday, with the Dow Jones Industrial Average DJIA tallying a fresh record high. The Dow gained 65.44 points, or 0.2%, at finish at 41,240.52.
Meanwhile, the S&P 500 SPX fell by 17.77 points, or 0.3%, to 5,616.84. The Nasdaq Composite COMP was off by 152.03 points, or 0.9%, at 17,725.76.
-Joseph Adinolfi
This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
08-27-24 0753ET
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