MV Weekly Market Flash: What...
Well, in the end they went big. The Fed cut the Fed funds target rate by 0.50 percent, and for maybe the first time in this entire monetary policy cycle, the bond market got it right (futures markets had priced in about a two-thirds probability of a jumbo cut versus the more usual 0.25 percent increment). The stock market seems to be trying to sort out all manner of mixed emotions – closing down after bouncing around in the immediate wake of the announcement on Wednesday, then staging a rally for the ages yesterday, and back into a bit of an edgy pause in pre-market futures trading this morning. Naturally, the financial news channels are saturated with furrowed-brow panelists telling their viewers what will happen next. Do any of us know what to expect? Let’s consider the fairly scant supply of data from (relatively recent) past events from which one might venture to make a prognostication.
Sample Size Equals Small
The chart below shows the history of the Fed funds target rate going back to the beginning of 1984, 40-plus years ago, along with the price performance of the S&P 500. During this period there were five rate cut cycles of meaningful magnitude, four of which coincided with an economic recession.
As you can see from the chart, the answer to the question “what can we expect?” over the course of a sustained monetary easing cycle would aptly be: “just about anything.” The one easing cycle that did not coincide with a recession – between 1984 and 1986 – delivered a nice cumulative return of close to 40 percent over the roughly two year duration of the cycle. The cycle that followed, which encompassed the 1990 recession, produced a somewhat more modest but still decent stock market return of around 35 percent over its duration of three and a half years.
Each of the next two easing cycles had a different story to tell. The Fed started to lower interest rates about ten months after the S&P 500 hit its tech bubble peak in March 2000. This easing cycle coincided with what was then the largest peak-trough decline in the US stock market since the end of the Second World War. Four years after that easing cycle ended, the wheels were starting to come off the financial system as we lurched into the global financial crisis and contemporaneous Great Recession. The Fed started to cut rates in the fall of 2007, but there wasn’t much that looser monetary conditions could do to cushion the blow of overleveraged mortgage-backed derivatives exposure on the books of systemically critical financial institutions as real estate prices declined in tandem across the entire country.
Recession Or No Recession?
Is there anything we can learn from these past cycles to give us a sense of what might come next (we are not giving too much thought to the rate cut cycle of 2019 – 2020, because of the uniquely distorting effects of the Covid-19 pandemic that pushed the Fed into its zero interest rate policy)? Well, the sample size is too small to be statistically significant. But just looking at the data might tell us that, from a share price returns perspective, it’s perhaps okay to have a mild recession (like in 1990) but not at all okay to have a recession and a financial markets crisis at the same time (2001, 2008). Even better if we avoid a recession entirely, which, while by no means a certainty, remains our baseline scenario based on the macroeconomic picture we have today.
What drove the Federal Open Market Committee to its decision to opt for the bigger cut this time? Most likely, it was the series of labor market data that came out subsequent to the previous FOMC meeting at the end of July. Most of that data (including a major downward revision by the Bureau of Labor Statistics of earlier jobs reports) pointed to a significant cooling of the labor market. With inflation seemingly under control and trending towards its two percent target, the Fed turned to the other side of its dual mandate and decided to buy a little extra insurance against a further worsening of labor market conditions.
Will that be enough, or will it turn out to be too little, too late? We will have our next batch of jobs data in two weeks, and then a snapshot of general consumer health as we move into the holiday season. Sentiment among retailers seems to be trending optimistic for now (and this week’s retail sales number came in ahead of expectations). That could change, of course, but for now we do not see a compelling reason to pull back in a meaningful way from the growth-focused components of our portfolios.