Yesterday, the Federal Reserve decided to launch the latest monetary easing cycle by going big with a half point cut to the Federal Funds Rate (FFR), instead of just a typical quarter point reduction. Market expectations had been notably shifting in that direction over the past several days, apparently with good reason this time. Why did they feel the need to kick things off with a bang? For a variety of reasons, but a couple stand out – beginning with further progress on inflation receding closer to their 2% target while a growing list of indicators suggest that the labor market may be cooling off more quickly than they’d like. In addition, they have plenty of room to lower rates from their current restrictive setting before they approach the level that they estimate is the “neutral” rate, which is theoretically where the FFR neither stimulates nor dampens economic activity. According to their updated projections, the long-run neutral rate is just shy of 3%, so clearly part of their thinking was why not begin to move in that direction more quickly then? After all, if accurate, anything above that still represents a restrictive policy stance even as the FFR is gradually reduced.
Investors are naturally wondering what the implications are for the stock market, and the data does suggest a reason for optimism as this easing cycle unfolds – with one major caveat. Examining the past eight easing cycles going back to the early 1980s shows that forward returns over the next 6, 12, 18, and 24 months following an initial rate cut were indeed positive (horizontal black markers on 2nd chart). However, the underlying reason for the rate cuts has a significant influence on the outcome: sometimes, the Fed is scrambling to cut rates because the economy is careening into a recession (e.g., 2001 or 2007), and other times they are attempting to proactively recalibrate rates to a lower level to help achieve a soft landing and extend an economic cycle (e.g., 1984 or 1995).
On that note, reviewing the data shows that in four of the eight easing cycles the economy experienced a recession sometime within the next 12 months following an initial rate cut. Forward returns in those four instances were actually negative on average as far out as 18 months (blue bars). Conversely, in the other four easing cycles, the economy managed to avoid a recession within 12 months following the initial cut, and in those cases forward returns were skewed well above average across all timeframes (orange bars). With the economy currently still on solid footing, the Fed is very much in “recalibration” mode this time, which is a word that Chair Powell used several times in his press conference yesterday.
Of course, we’ll have to remain on the lookout for signs that the economy is slowing too much in the months ahead, but history says that an economic soft landing (i.e., no recession in the next 12 months) cushioned by lower interest rates has the potential to be a very positive environment for stocks.
Source: CNBC, Federal Reserve Bank of New York, as of 9/18/24
Source: Bloomberg, CW Advisors, as of 9/18/24
Carl Noble, CFA
Senior Vice President of Investments
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