NEW YORK, Sept 16 (Askume) – The performance of stocks, bonds and the U.S. dollar will largely depend on one factor as the Federal Reserve begins its interest rate cutting cycle: the health of the U.S. economy.
The Federal Reserve is expected to unveil a series of interest rate cuts on Wednesday as borrowing costs have risen to their highest level in nearly two decades. The market expects rates to be reduced by about 250 basis points by the end of 2025, data from the London Stock Exchange show.
The main question for investors may be whether the Fed will cut interest rates in time to avert a potential recession.
Evercore ISI data going back to 1970 shows that if the economy slips into a recession, the S&P 500 (.SPX) falls an average of 4% in the six months following the first rate cut in a rate-cutting cycle. That’s compared to a 14% rise in the S&P 500 after the Fed cuts interest rates in a non-recession period. The index will rise 18% by 2024.
“If the economy slides into a recession, interest rate cuts will not be enough to offset the drop in corporate profits and the high level of uncertainty and lack of confidence,” said Keith Lerner, co-chief investment officer at Truist Advisory Services.
US Treasuries have performed better during recessions as investors seek the safety of US government bonds. Also, the US dollar tends to lose value during recessions, although its performance may depend on how the US economy performs compared to other countries.
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The National Bureau of Economic Research typically refers to recessions as post-recessions, and economists have found little evidence that the U.S. is currently in a recession.
If this continues, these are good signs for US stocks to rise.
“Based on past easing cycles, our expectations of a sharp rate cut and no recession would correspond with strong returns for U.S. equities,” James Reilly, senior market analyst at Capital Economics, said in a note.
Still, concerns about the economy have shaken asset prices in recent weeks.
Weakness in the US labor market has fueled sharp fluctuations in the S&P 500 index, and concerns about global economic growth have been reflected in falling commodity prices, with Brent crude oil trading close to its lowest level since late 2021.
Uncertainty remains over whether growth rates are returning to their long-term trend or showing signs of a more severe slowdown, the impact of which is also evident in futures markets.The futures market has fallen or is oscillating below 25 on Wednesday .
The state of the economy is also important for investors who want to predict long-term stock performance. A study by Ryan Detrick, chief market strategist at the Carson Group, shows that after the first interest rate cut during a recession, the S&P 500 declined by an average of about 12% per year.
This compares with an average growth rate of 13% in non-recession periods following rate cuts to “normalise” policy, based on data looking at the last 10 easing cycles.
“The key takeaway from this whole thing is that the economy can avoid a recession,” said Michael Allen, chief investment strategist at State Street Global Advisors.
Overall, the S&P 500 has risen 6.6% in the year following the first rate cut in this cycle, about a percentage point below the annual average dating back to 1970, Evercore data shows.
Among S&P 500 stocks, consumer staples and consumer discretionary stocks performed the best on average, both rising by about 14% after the rate cut, while health care gained about 12% and technology rose by about 8%, according to Evercore.
Small-cap stocks, considered highly sensitive to signs of economic change, have also performed well, with the Russell 2000 index (.RUT) rising 7.4% over the past year.
Treasury bills
Bonds have been a profitable bet for investors at the start of the rate-cutting cycle. However, US Treasuries have risen this time, and some investors believe further gains are unlikely until the economy slows.
When the Federal Reserve eases monetary policy, Treasury yields, which move inversely to bond prices, will fall along with interest rates. The safe-haven reputation of U.S. government bonds makes them a popular investment destination in times of economic uncertainty. Citi strategists found that the average return of the Bloomberg U.S. Treasury Bond Index was 6.9% in the 12 months after the first interest rate cut, but the return rate was 2.3% in the economic “soft landing” scenario.
The benchmark 10-year Treasury yield has fallen about 20 basis points this year and is near its lowest level since mid-2023.
Further gains in U.S. Treasuries may be less certain without a so-called hard landing for the economy, which would force the Federal Reserve to cut interest rates more than expected, said Dirk Willer, Citi’s head of global macro and asset allocation strategy.
“If there’s a hard landing, then yes, there’s a lot of money on the table,” Villar said. “It’s actually a little bit unclear whether it’s a soft landing.”
That being said, investing early is key. Over the past 10 rate-cut cycles, 10-year Treasury yields have fallen by an average of 9 basis points after the first rate cut and increased by an average of 59 basis points a year after the first rate cut, CreditSight data shows, as investors began to price in the economic recovery.
Dollar
The US economy and the activities of other central banks are important factors in determining how the dollar reacts to the Fed’s easing cycle.
Recessions often necessitate further interest rate cuts from the Federal Reserve, and lower interest rates make the dollar less attractive to yield-seeking investors.
A Goldman Sachs analysis of the past 10 interest rate cut cycles shows that a year after the first rate cut, when the economy has not yet entered recession, the dollar has gained an average of 7.7% against a basket of trade-weighted currencies. By comparison, US growth during recessions averaged 1.8%.
Meanwhile, according to another analysis by Goldman Sachs, when the US joins several central banks in cutting interest rates, the US dollar tends to outperform other currencies. On the other hand, relatively few major banks are leading the rate cutting cycle, often resulting in the dollar underperforming.
Work continues on the possibility of rate cuts by other central banks .The European Central Bank , the Bank of England and the Swiss National Bank are all cutting interest rates.
The US dollar index, which measures the greenback’s strength against a variety of currencies, has weakened since late June but is still up about 9% over the past three years.
“The US growth rate is still slightly better than most countries,” said Yongyu Ma, chief investment officer at BMO Wealth Management. “Although the dollar has strengthened significantly, we cannot expect the dollar to weaken significantly.”
That could change if U.S. economic growth slows, BNP Paribas analysts wrote.
“We believe this time, amid a potential recession, the Fed will cut rates more than other central banks, further reducing (the dollar’s) yield advantage and weakening the currency,” he said.
