Market Outlook

October 1, 2024

What Market History Suggests About September’s Rate Cut

As we’ve all been taught, the past is often prologue. But since the start of this century, market history has sometimes led us astray. Most recently, the yield curve was once pretty reliable at forecasting recession. But not in our post-pandemic economy. And certainly not at a time when an activist Fed, combined with two free-spending presidents and several profligate Congresses, have used extreme monetary and fiscal tactics to prop up the economy (and I’d argue, the financial markets, too). So while it remains to be seen how our $35 trillion deficit-time-bomb will be diffused, the Fed deserves a victory lap because we are all likely enjoying the economy’s long-sought soft-landing.

But where do we go from here? The half-percentage- point cut should help to maintain the economy’s growth (which was 3% in the second quarter). But the U.S. is not an economic island. Indeed, the strength of our major trading partners is anemic (especially Europe and Japan), while China’s relative growth rate continues to contract (though it took significant steps last month to turbocharge its economy).

And, speaking of history, next month we choose a president. I’ll show my hand: Both candidates have floated tax, trade and spending ideas that I find populist and head-scratching. So how might their schemes affect future market returns? Perhaps the past holds some clues.

Looking Back
In the 12 months following an initial Fed rate cut (which, in turn, has been followed by a prolonged period of easing), there tends to be an uptick in market volatility. Recalibrating stock and bond valuations contribute to that rise, but it may also be instigated by investor angst: rate cuts sometimes signal the Fed’s wariness over a slowing economy.

Though the 50-basis point cut was just two weeks ago, volatility has been muted, and stocks have drifted only slightly higher. However, in the seven 12-month periods following initial cuts (since 1984), the S&P 500 has risen on five occasions for an average gain of 26.2% (excluding dividends). On the other two occasions, which were precipitated by the Financial Crisis (Sept. 2007) and later by slow growth, low inflation and arguably political pressure (July 2019), stocks fell an average of 14.0% in the following 12 months. (That period includes the start of the Pandemic.)

If one believes that the two bear market declines of -10.0% and -17.8% were anomalies, the most important takeaway is that the S&P 500 has enjoyed gains of 10% to 23% following the first in a series of cuts.

On the bond front, the news is mixed. Duration-wise, a lower Fed Funds rate inevitably leads to lower yields (higher prices) on shorter-term Treasury bills and notes.

But the benchmark 10-year Treasury is another matter. Over the same seven periods examined, its yield eased an average of only 29 basis points 12 months after the initial cut.

On the four occasions the yield on the 10-year rose, it backed up an average of roughly a half percentage point. During the three remaining periods, it did the exact opposite, falling around a half percentage point.

Two Weeks "Out"
Since Sept. 17 (the day before the cut), yields have indeed flip-flopped. As the chart shows, the Fed’s influence on the short end of the yield curve was immediate as yields have fallen 12 basis points on the 1-month to as much as 22 bps on the 2- and 3-month. But from 2 years and out, yields have slightly risen. For its part, the 10-year rose 16 bps to 3.81%, but is flat on the month. (For all of September, the picture is different: Fidelity’s taxable funds rallied as yields fell across the entire maturity spectrum.)

With quarter-point cuts likely in November and then December, the table appears set for short- to intermediate-term bond funds to gain more ground. On the other hand, longer-duration bonds, which are the most sensitive to interest rates (both up and down), still give us pause. For one thing, the 20% post-pandemic rise in inflation has Americans wanting significant wage increases. And it’s not just Boeing employees and dockworkers demanding them — municipal workers want them, too. Naturally, higher wages are inflationary, as are many economic notions proposed by White House contestants. With inflation dying, but not dead (it’s officially at 2.5%), we rate Long-Term Treasury Index (Fidelity’s most interest-rate sensitive bond fund) OK to Sell, and we’re still cautious about intermediate-term funds.

Returning to stocks, if the coming series of rate cuts are seen by investors as the Fed’s response to falling inflation rather than insurance against recession, market sentiment will support higher share prices. That’s providing corporate earnings growth is also sustained.

Of course, the seven post-cut periods we examined are unique, and so is the one we’re in. Indeed, the best investment advice remains unchanged: invest in accordance with your tolerance for risk.

All Eyes On Powell
In any event, while Main Street will be watching Mr. Trump and Ms. Harris with greater scrutiny over the next nine weeks, Wall Street is laser-focus on Mr. Powell’s every utterance.

With unemployment rising and employment growth having been wildly overstated, recession fears quickly gripped the market last month: stocks tumbled, while bond investors played the steadier hand. Notably, credit spreads didn’t widen much, meaning investors saw no reason to be paid a higher risk premium.

Fed Expectations
So what should we expect from Chairman Powell’s Fed this month and the rest of the year?

While its policies are mostly data-driven, Powell isn’t tone deaf to market sentiment or, for that matter, shifting political winds.

As to the latter, the Fed will be careful not to signal any recession risk ahead of the vote. To me, that suggests three quarter-point cuts this year. Though shy of the 100 bps the market seems to have priced in, some verbal hand-holding should quell the disappointed. Of course, a 50-bp cut this month is also possible, as that might be viewed as insurance against a hard landing.

With about half the country certain to dislike November’s election outcome, Powell’s past role as "calmer-in-chief" during the last stock- and credit-market meltdowns may prove beneficial should the need arise.

But if history is prologue, it’s worth reminding that stocks climbed a wall of worry during the last presidential transition: investors were fine with the executive and legislative branches sharing power. That may not be the case this time around. At least Jerome Powell is trusted among lawmakers and Wall Street. He’s the rare Washington insider whose steady hand served the country well during times of crisis. Both presidential candidates should be mindful of his counsel.

— John Bonnanzio