Federal Reserve Chairman Jerome Powell delivered a speech in which he said the following:
“The time has come for policy to adjust… The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks… Inflation has declined significantly. The labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic. Supply constraints have normalized. And the balance of the risks to our two mandates has changed.”
Financial markets, for now, view this shift to a more accommodative monetary policy as a positive event for asset prices. Are they correct?
Well, historically, it has depended on why the central bank is cutting rates.
As you can see in the table above, stock market performance after an initial interest rate cut has depended upon the general economic landscape.
Presently, most investors are assuming that the Fed is ahead of the curve and will begin cutting rates to stave off a recession—a Soft Landing. In prior episodes where the Fed was able to engineer a soft landing of the economy, stock prices were generally up 10% over the next six months. Unfortunately, there aren’t many examples where they’ve been able to accomplish this.
In the majority of instances when the Fed began to cut interest rates, they were already behind the curve and reacting to deteriorating economic data—a Hard Landing. The hard landings saw stock prices decline sharply in the first three months after the initial rate cut but rebounding to just slight losses over the initial six months.
Ironically, the best stock market outcomes after the initial rate cut are those that are reacting to a sharp crash in asset prices. In those prior periods, stock prices were up nearly 20% during the first six months after the initial rate cut.
So while the markets today are reacting as if the Fed is engineering a soft landing, it will be important to monitor the economic data over the next few months to see if they are, in fact, ahead of the curve.
For now, we are inclined to think that the economy is doing ok. While growth will moderate over the next year, we aren’t seeing the broad signs of economic distress that normally signal a recession—yet.
