US Interest Cut is Coming, Are You Ready?
US Interest Cut is Coming, Are You Ready?
What can history teach us about this pivotal moment, and how should investors prepare for the road ahead?
Today, the latest nonfarm payroll data has revealed: Unemployment remained little changed at 4.2% over the month as expected, but climbed against the 3.8% recorded a year earlier. 142,000 jobs were added, against 114,000 in July and below expectations for 160,000. This follows Federal Reserve Chairman Jerome Powell's statement at the Jackson Hole meeting on August 24th, declaring that "the time has come for policy to adjust." While the start of the rate cut cycle is certain, the pace and depth remain highly uncertain. What can history teach us about this pivotal moment, and how should investors prepare for the road ahead?
Q&A on the Rate Cut Expectation
Question 1: How Many BPs Could the Fed Cut in September?
Looking back at the past six rate cut cycles, the first cut was 50bps in two instances, 25bps in three, and 13bps in one. A 25bps cut is typical, and only in the event of a crisis or a sharp decline in U.S. stocks would the Fed cut by 50bps.
Currently, while the U.S. labor market is cooling and inflation is falling, the situation has not yet reached the level of an economic recession or crisis. An August report from Bank of America’s investment managers shows that 87% of investors believe in either a soft landing or no landing for the economy. According to CME FedWatch, the likelihood of a 25bps cut in September remains in majority of 56%, polled with interest rate traders.
Question 2: How Many BPs Will Be Cut Over the Next Year?
Based on pricing in the interest rate futures market, the market currently expects the Fed to cut rates three times this year, totaling 75bps, with cuts 25bps each in September, November, and December. A total of 200bps in cuts is expected over the next year, meaning an additional 100bps cut in the first three quarters of next year.
In the last three rate cut cycles, the Fed has cut rates by more than 200bps within a year after the first cut. Observing closely, this significant reduction in a short time frame occurred only under certain conditions: 1) an economic recession, 2) a sharp drop in U.S. stocks, or 3) a black swan event (such as the 9/11 attacks in 2001, Lehman Brothers' collapse in 2008, or the COVID-19 pandemic in 2020). In each case, the black swan event occurred several months after the start of the rate cut cycle, accelerating the pace of cuts.
Question 3: Is This Rate Cut Cycle Similar to Any First Rate Cut in History?
Currently, the Fed’s rate cuts are preemptive rather than reactive crisis management, similar to the situations in 1995 and 2019. After the 1995 rate cut cycle began, the Fed cut rates three times, totaling 75bps, before ending the cycle. In 2019, the Fed also cut rates three times, totaling 75bps. However, it wasn’t until the COVID-19 pandemic hit in March 2020 that the Fed made an emergency cut of 150bps.
Data shows that while the labor market is cooling, the average monthly job growth in July this year reached 164,000, higher than the 114,000 in 2019. However, the unemployment rate is significantly higher than in 2019 and shows a rising trend. In terms of inflation, month-on-month CPI data is similar to 2019, but year-on-year figures are higher. Additionally, the current PMI data is significantly lower than in the same period of 2019, indicating weaker economic conditions.
So, will this rate cut cycle resemble 1995 or 2019? Both scenarios are possible, depending on whether a crisis unfolds later. As Powell said, future monetary policy adjustments will depend on the data, changing outlooks, and risk balance. Looking ahead, the market will continue to adjust its expectations for rate cuts. U.S. Treasury yields are unlikely to decline steadily, with large fluctuations being more common.
Question 4: How did the rate cut affect stock market historically?
Historically, rate cuts by the Federal Reserve (Fed) have had significant and varied effects on the stock market. The relationship between rate cuts and stock market performance can be complex, influenced by a variety of factors such as the overall economic environment, investor sentiment, and the reason for the rate cuts.
Short-term Market Reaction: Typically Positive
Immediate Boost: When the Fed cuts interest rates, it typically signals that borrowing costs will be lower, which can stimulate economic activity. This often leads to a short-term rally in stock markets, as businesses benefit from cheaper loans and consumers spend more due to lower interest rates on mortgages, credit cards, and other debts.
Historical Example: After the Fed cut rates in July 1995, the S&P 500 surged by 12.69% over the following six months. Similarly, when the Fed cut rates in 2001 and 2007, the stock market reacted positively with in 1 month.
Long-term Effects: Mixed Outcomes
Depends on the Economic Context: If rate cuts are perceived as a preemptive measure to prevent an economic slowdown, stock markets often react positively in the long term. However, if cuts are made in response to a recession or a major crisis, markets might remain volatile.
Crisis-driven Rate Cuts: During the 2008 financial crisis, the Fed slashed rates aggressively to stabilise the economy. While these cuts were intended to revive the economy, stock markets remained volatile due to the underlying economic instability.
In 2008, despite rate cuts, the S&P 500 fell sharply as the financial crisis deepened. It wasn’t until after the crisis abated and quantitative easing (QE) was introduced that markets recovered significantly.
For Investors, How to Allocate Asset Structure and Manage Risks?
With the high likelihood of the Federal Reserve initiating a rate-cutting cycle, global markets may gradually enter a more accommodative monetary environment, which is more favorable for equity assets and growth-oriented strategies. Currently, U.S. economic data does not strongly indicate a recession, so we lean towards viewing this rate cut as precautionary. Given the strong fundamental data and manageable recession risks during the rate-cutting process, U.S. equities remain promising. However, we must be cautious of the bond market, which may have already priced in much of the optimism. Since April 2024, the yield on 10-year U.S. Treasuries has dropped by over 80 basis points, and this downward trend may continue until the first rate cut. That said, there may be limited downside after the rate cut is implemented. Similarly, gold has surged by 22% this year, and after the rate cut, it may face a correction.Small-cap U.S. stocks, compared to the previously surging tech giants, could benefit from valuation corrections and capital flows under rate-cut expectations.
However, we must not ignore the possibility of a rate cut driven by economic weakness. In this scenario, equity assets could face significant downward pressure, while the downward trend in U.S. Treasuries may persist for a longer time.
Historically, each Fed rate cut has influenced the volatility characteristics of various financial assets and impacted global capital flows through mechanisms such as exchange rates and carry trades. Therefore, in the face of potential shocks from Fed rate cuts, it is necessary to adjust portfolios accordingly.
Created by Yiding
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