Stock-market Bulls Should Be Careful What They Wish For When It Comes to Fed Rate Cuts

Investors bullish on equity markets and hopeful for a gentle economic slowdown find solace in the prevailing market sentiment, which anticipates the Federal Reserve implementing a substantial 1.5 percentage points reduction in its key lending rate throughout 2024.

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However, a closer examination of historical patterns unveils a critical nuance that may temper this optimism. Jim Reid, a strategist at Deutsche Bank, underscores a noteworthy observation in a Tuesday note, highlighting that when the Federal Reserve has historically executed a 1.5 percentage points, or 150 basis points, interest rate cut within a year, it has predominantly occurred in response to a recession (as illustrated in the accompanying chart).

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The recent past witnessed a robust upswing in stock markets, culminating in the Dow Jones Industrial Average achieving numerous record closes. Simultaneously, the S&P 500 notched up a total return exceeding 26%, concluding the year with a mere 0.5% variance from its record finish on January 3, 2022. While stocks have experienced a minor retracement at the onset of the new year, the trajectory of the 2023 rally gained momentum as investors factored in an anticipated shift in Fed policy towards lower interest rates.

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Although rate traders have moderated their expectations for rate cuts in 2024, the CME FedWatch tool indicates a prevailing sentiment, with fed-funds futures projecting a 53.8% likelihood of the fed-funds rate declining by 150 basis points or more by December.

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The historical context, as depicted in the chart, exhibits a singular exception in the 1980s when Paul Volcker helmed the Federal Reserve. Notably, this departure from the recessionary trend occurred subsequent to the Fed's deliberate escalation of rates into what was deemed "super-restrictive" territory. This specific instance, therefore, lacks direct comparability to the current economic landscape.

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Another anomaly in the late 1960s is acknowledged by Reid, but he underscores the distinct circumstances of that era. This deviation coincided with a substantial surge in public spending attributable to the Vietnam War, resulting in a subsequent rise in inflation that, in retrospect, was deemed a policy error. Crucially, Reid emphasizes that the Fed is actively striving to avert a recurrence of such a scenario.

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Drawing on historical precedence, Reid contends that the prevalent environment, characterized by expectations of significant rate cuts, is more historically associated with recessionary conditions than a smooth economic deceleration. He posits that if a recession fails to materialize, historical patterns suggest that achieving a 150 basis points reduction over a 12-month period may pose a formidable challenge. Thus, the trajectory of the equity markets may be more intricately linked to economic indicators and potential recessionary signals than initially presumed.