Stock History Makes Case for Limited Rate Cuts

Investors and politicians jockeying for a long cycle of interest-rate cuts from the Federal Reserve should be careful what they wish for.President Trump has criticized the central bank’s monetary policy, calling for the Fed to reduce short-term rates to “ZERO, or less” to help bolster the U.S. economy. But history has shown that the stock market tends to fare well when the central bank takes a more measured approach.

Fed Chairman

Jerome Powell

has sought to draw parallels to 1995 and 1998, when the Fed started cutting rates three times. In both cases, the economic expansion continued and the S&P 500 rose 15% and 8.6%, respectively, from when the central bank first lowered borrowing costs to when it last cut them, according to Dow Jones Market Data.

Stocks gained during the series of rate cuts that began in 1995 and 1998.

Photo:

Michael Nagle/Bloomberg News

That compares with declines of 28% and 40% for the index during the extended rate-cutting cycles that began in 2001 and 2007—both of which were recessionary periods. “If this is the beginning of a full-blown rate-cutting cycle by the Fed, stocks don’t do well after the first cut,” Mike Wilson, equity strategist at Morgan Stanley, said in a research note. “On the other hand, if the cut is not associated with a further slowdown, but rather with a reacceleration or stabilization in growth, then equity markets have a chance to move higher.” In five prior rate-cutting cycles since 1984 that have happened outside of recessions, the S&P 500 on average rose 11% over the subsequent six months and 16% over the next year from the first cut, according to LPL Financial.

Speaking on a panel in Switzerland, Federal Reserve Chairman Jerome Powell said the Fed wasn’t expecting a recession and that the U.S. economy was in a good place. Photo: Arnd Wiegmann/Reuters

The index has ticked up 0.6% since the Fed cut rates in July for the first time since the depths of the financial crisis in 2008. It is up 20% for the year and within 1% of July’s all-time closing high, but investors remain on edge in the midst of uncertainty over the U.S.’s long-simmering trade war with China and signs that weakness abroad is starting to spill over into the domestic economy. The Fed is widely expected to lower interest rates following its two-day meeting Wednesday for the second time in three months. But a batch of mixed data on the health of the U.S. economy has left investors unsure about the direction of future Fed policy.

Federal-funds futures, used by investors to place bets on the course of central-bank policy, point to a 68% chance the Fed will cut rates this week, according to data from

CME Group
.

That is down from 95% a week ago, easing after strong retail-sales data Friday signaled that Americans continued to boost spending in August. The rate outlook beyond this week is less clear, however, as other economic data remain muted. Hiring slowed in August, and factory activity has eased. Now the market is pricing in just a 41% chance of a third rate cut by the end of 2019, down slightly from a week ago.

Some analysts and investors have said the Fed likely has a limited easing path in light of recent consumer-price data that has pointed to an uptick in inflation. Meanwhile, a surge in oil prices following a weekend attack on Saudi oil facilities has raised concern about a pickup in inflation, which could prevent the Fed from cutting rates aggressively. “We wouldn’t label this as a ‘rate-cutting cycle,’” said Adam Phillips, director of portfolio strategy at EP Wealth Advisors. “That would imply the U.S. economy is in need of a rescue, and we don’t see this risk of a recession being too high right now.” To receive our Markets newsletter every morning in your inbox, click here. Write to Jessica Menton at Jessica.Menton@wsj.com

Share Your Thoughts Are you making any changes to your portfolio because of the possible rate cut? Or will you do so if it happens? Join the conversation below.

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