The Markets Rely on Powell Emulating Greenspan to Avoid a Recession

Traders are drawing comparisons to 1995 when Federal Reserve Chair Alan Greenspan managed to achieve a rare soft landing for the U.S. economy. Now, with the Federal Reserve poised to make its first interest rate cut in four years, they are looking back to that period for guidance on market moves.

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Much like nearly 30 years ago, both bonds and stocks are seeing gains ahead of a key Fed meeting. However, this time around, the main question facing Chair Jerome Powell is whether a rate reduction of 25 basis points or 50 basis points would better support the U.S. economy.

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According to Kristina Hooper, chief global market strategist at Invesco, the U.S. economy appears likely to avoid a recession as the Fed moves toward easing monetary policy just before the U.S. presidential election. "Once the Fed starts to cut, there will be a psychological reaction to that," Hooper noted, suggesting that such a move would provide market support.

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Historically, the S&P 500 Index, Treasuries, and gold have tended to rise when the Fed begins to cut rates, according to a Bloomberg News analysis of market behavior during the last six rate-cutting cycles dating back to 1989. In the stock market, the S&P 500 has typically increased by an average of 13% in the six months following the Fed's initial rate cut, with the exception of the recessionary periods in 2001 and 2007.

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Short-term Treasuries have generally outperformed longer-term notes during these easing cycles, a trend known as yield curve steepening. Six months after the first rate cut, the gap between the yields on 10-year and two-year Treasury bonds often widens by an average of 44 basis points. Meanwhile, gold has delivered positive returns in four out of the last six Fed easing periods, while the performance of the dollar and oil has been mixed.

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Nonetheless, there is considerable uncertainty among traders in the months ahead. The Fed's rate-cutting path coincides with the upcoming November election, where former President Donald Trump and Vice President Kamala Harris are presenting contrasting economic policies. The results of the election could have significant implications for global markets, depending on the direction of congressional votes.

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Salman Ahmed, Fidelity International's global head of macro and strategic asset allocation, believes that a soft landing remains the most likely outcome. However, he has downgraded his view of U.S. equities from overweight to neutral, partly due to election-related risks. "But elections are going to matter," he emphasized. "It’s probably a unique cycle."

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On the campaign trail, Republican nominee Trump has proposed imposing higher tariffs and extending tax cuts, a policy mix that could be positive for the dollar but negative for bonds. Goldman Sachs economists have warned that Trump's tariffs, if enacted, may lead to increased inflation. Additionally, his plan to lower the corporate tax rate from 21% to 15% would likely boost corporate earnings. In contrast, Democratic candidate Harris has suggested raising the corporate tax rate to 28%, which Goldman Sachs estimates could reduce corporate earnings by approximately 5%.

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In previous easing cycles since 1989, the Fed has successfully avoided an immediate economic downturn only twice — in 1995 and 1998. Investors are now hoping for a similar outcome this time. Back in 1995, Greenspan and the Federal Reserve cut rates from 6% to 5.25% over a six-month period, successfully cooling the economy without triggering a recession. During the 12 months following the first rate cut, U.S. Treasury yields increased, and total returns on bonds lagged behind cash.

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Currently, the Federal Reserve has held its benchmark target range steady at 5.25% to 5.5% for 14 months, refraining from committing to an aggressive rate-cutting strategy. Bond traders are currently pricing in more than 2 percentage points of easing over the next year. Meanwhile, the S&P 500 is hovering near an all-time high, and credit spreads are at historically low levels.

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What gives investors hope for a soft landing this time around is the strength of corporate and household balance sheets. With corporate profits and household wealth at record highs, both sectors appear more resilient to potential economic shocks. "Inflation is no longer the big problem the economy and the stock market face — it’s high interest rates," said Yung-Yu Ma, chief investment officer at BMO Wealth Management. He added that if the Fed cuts rates now, it may alleviate this issue and help avert a downturn.

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This sentiment is prompting traders to position themselves for lower borrowing costs and a relatively robust economy. According to the latest equity flow data from Bank of America Corp. and EPFR Global, there is a notable shift into utilities and real estate sectors. Historically, these sectors have benefited from rate cuts, provided that economic growth remains strong.

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