Wall Street Game Plans the Market Reaction to a Fed Rate Cut
Bloomberg – With expectations for Federal Reserve interest rate cuts increasing among investors and economists alike, some of the biggest U.S. banks are mapping out the implications for financial markets.
Strategists at JPMorgan Chase & Co. and Goldman Sachs Group Inc. are among those mining history and running models to divine the potential path for different asset classes.
Here’s what the market watchers are saying so far:
JPMorgan strategists including John Normand and Nikolaos Panigirtzoglou:
“We favor the optimistic view but conviction is not high.”
Mid-cycle easing by the Fed can renew bull markets, but cuts prior to recessions simply extend bear trends. JPMorgan’s recession-risk model suggests the upcoming Fed cycle may be a bad one for risky markets, but underlying leverage dynamics suggest that these cuts should support markets.
Bonds don’t tend to rally sustainably during mid-cycle easing because the Fed reverses those insurance cuts eventually. Recessions tend to generate bond rallies until about nine months after the first easing; that’s approximately when activity data are reviving. Equity markets appear to be pricing in a pre-emptive Fed that is set to provide insurance; if the Fed ends up being reactive, equities could follow a weak trajectory.
History shows that Treasury yields continued to rally and the curve continued to steepen for up to six months on average after the first rate cut. Credit spreads widened on average during the first six months. The dollar was on average on an upward trajectory for up to three months.
Goldman Sachs strategist David Kostin and team:
“The S&P 500 index has typically generated strong returns at the beginning of Fed cutting cycles.”
Goldman analyzed equity returns during the past 35 years following the start of seven Fed cutting cycles. The index climbed by a median of 2% and 14% during the 3- and 12-month periods following the start of a Fed cutting cycle, respectively.
If the Fed doesn’t plan to cut, it will need to walk back market expectations, and the few previous instances suggest that the S&P 500 would fall in that case. If the Fed does cut, Health Care and Consumer Staples tend to outperform and Information Technology consistently lags. Momentum and low volatility factors also outperform.
“Few precedents exist during the past 30 years where futures discounted an interest rate cut 30 days prior to a scheduled FOMC meeting but the Fed did not cut.” There were episodes in 1990 and 1992, but unlike today, both occurred in the middle of easing cycles.
Morgan Stanley’s Sheena Shah and Andrew Watrous:
The Fed rate-cut cycles since 1995 can be divided into two types: pre-euro and post-euro.
The pre-euro cuts — in 1995, 1998 and 2001 — resulted in the dollar rallying over the six months following the cut. The greenback’s performance before the rate cut had little significance for how it performed after the rate cut.
Following the post-euro cuts — in 2002 and 2007 — the dollar weakened significantly, around 10%. The currency’s realized and implied volatility picked up.
The bank’s cross-asset team expects the Fed to stay on hold until financial conditions tighten, by which time action will be too late to avoid cyclical impacts. They are underweight equities and credit and overweight high-quality bonds.
Wells Fargo & Co.’s Pravit Chintawongvanich:
“Although stocks have rallied with lower rates, they may start to sell off (or at least have limited upside) if rates keep declining.”
At some point the upside from “bad is good” is limited. An “insurance cut” scenario is already priced in, and would likely be positive for stocks; the Fed cutting more than one or two times by the end of the year would probably mean that the economy has significantly slowed and/or the trade war has escalated.
Chintawongvanich sees volatility elevated and potentially limited upside for stocks before the G-20 meeting. He says consider selling June VIX puts as VIX settlement is right before the Federal Open Market Committee decision. That VIX settlement will be based on 30-day option prices that “contain” the upcoming FOMC and G-20 meetings, and may keep a bid. Investors could sell the June puts to fund July puts, he adds.