How markets would fare after the first US rate cut

How stocks, bonds and the dollar perform after the Federal Reserve begins to cut its rate may depend on one factor more than many: the health of the US economy.

The Federal Reserve is expected to begin a series of rate cuts on Wednesday, after raising borrowing costs to their highest levels in nearly two decades. Prices are set to rise by about 250 basis points by the end of 2025, LSEG data showed.

For investors, the key question may be whether the Fed will cut rates in time to prevent a major recession.

The S&P 500 fell an average of 4% in the six months after the first rate cut cycle, if the economy was in 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 the non-tapering period. The index is up 18% in 2024.

Keith Lerner, chief investment officer at Truist, said: “If the economy is in recession, a rate cut is not going to do enough to reduce business profits and high levels of uncertainty and lack of confidence.” Consulting Services.

Treasuries have performed better during the recession, as investors seek the safety of US government bonds. Meanwhile, the dollar tends to rise slightly during the recession, although its performance may depend on how the US economy fares compared to others.

Stocks

A recession is often called foreshadowing by the National Bureau of Economic Research and currently, economists see little evidence that the US has one yet.

Those conditions bode well for a rally in US stocks, if they persist.

“Based on past cycles, our expectation of a strong slowdown and no recession will be consistent with strong returns from US equities,” said James Reilly, senior analyst at markets at Capital Economics, in a report.

However, worries about the economy have pushed up commodity prices in recent weeks.

Weakness in the US labor market contributed to a strong shift in the S&P 500, while concerns about global growth were reflected in a drop in commodity prices, while Brent crude traded near its level. down from the end of 2021.

Uncertainty over whether growth is returning to its long-term trend or showing signs of a significant slowdown is evident in futures markets, which in recent days have fluctuated between prices in 25 or 50 point discount on Wednesday.

Economic conditions are important to investors looking to gauge a stock’s performance over the long term, too. The S&P 500 was down an average of about 12% one year after the initial cut that occurred during the recession, according to research by Ryan Detrick, an analyst at in marketing at Carson Group.

That compares to an average gain of 13% after the decline that came in the offseason, when the decline was supposed to “normalize” the strategy, according to the data, which studies the last 10 cycles.

“The bottom line is that the economy is avoiding a recession,” said Michael Arone, chief investment strategist for State Street Global Advisors.

Overall, the S&P 500 was 6.6% higher in the year after the first cycle rate cut — about a percentage point lower than its annual average since 1970, Evercore data found.

Among the S&P 500 components, consumer prices and consumer discretionary had the best performance, both rising 14% in the year after the cut, while maintenance of life rose about 12% and technology gained about 8%, according to Evercore.

Small caps, seen as more sensitive to signs of economic change, also advanced, with the Russell 2000 up 7.4% over the year.

Assets

Bonds have been a boon for investors at the start of the rate cut. This time, however, the Treasury has already seen a major rally, and some investors believe it is unlikely to continue unless the economy collapses.

Treasury yields, which move inversely to bond prices, tend to fall along with rates when the Fed reduces monetary policy. The safe reputation of US government bonds also makes them a popular destination in times of economic uncertainty. The Bloomberg US Treasury Index returned 6.9% in the medium term 12 months after the first cut, Citi strategists found, but 2.3% in economic conditions “soft-landing”.

The benchmark 10-year Treasury yield has fallen nearly 20 basis points this year and is near its lowest level since mid-2023.

Other gains in the Treasury are likely to be limited without the so-called tightening of the economy forcing the Fed to cut rates more than expected, said Dirk Willer, global head of allocation policy. of Citi’s capital assets.

“If you sit tight, yes, there’s a lot of money on the table. If it’s an easy spot, it’s not very clear,” Willer said.

That said, getting in early can be important. The 10-year Treasury yield fell an average of nine basis points in the month following the first cut in the past 10 rate-cutting cycles, and rose 59 basis points in the year since the decline as investors begin to put a price on economic development. Data from CreditSights is shown.

Dollar

The US economy and the actions of other central banks have been key factors in determining how the dollar will react to the Fed’s rate cuts.

Recessions usually require deeper cuts from the Fed, with falling rates undermining the dollar’s appeal for yield-seeking investors.

The greenback has strengthened an average of 7.7% against a basket of major currencies in the year after the first rate cut in the non-recession period, Goldman Sachs’ analysis of the past 10 periods showed. That compares to a 1.8% gain over the same period when the US was in recession.

At the same time, the dollar tends to outperform other currencies as the US cuts close to the number of central banks, according to a separate analysis by Goldman Sachs. Rate-cutting cycles that see the currency move closer to a few major banks, on the other hand, often result in weaker dollar activity.

A rate cut near other central banks appears to be playing out now, with the European Central Bank, the Bank of England and the Swiss National Bank all cutting rates.

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

“America’s growth still looks better than most countries,” said Yung-Yu Ma, chief investment officer at BMO Wealth Management. Even though the dollar strengthened so much, we would not expect any dollar weakness.

That could change if US growth sputters, BNP Paribas analysts wrote.

“We think the Fed may cut more than other central banks in a potential recession this time around, further damaging (the dollar’s) yield advantage. and leaving money at risk,” they said.