The Fed Is Cutting Interest Rates: What Does it Mean for Investors?

“Don’t fight the Fed” has become the cardinal rule of many investors over the past 30 years. The idea is that when the Federal Reserve is raising rates, it slows the economy and investors should be bearish (cautious) on stocks. On the other hand, when the Fed is cutting rates, it stimulates the economy, and investors should be bullish (optimistic) on stocks.

Belief in this market mantra reached its zenith during the 2010s, as the Fed went beyond simply cutting rates and keeping them low in what was widely interpreted as an effort to support asset prices. Despite a litany of concerns over the course of the decade, those who “didn’t fight the Fed” found themselves repeatedly on the right side of the market’s impressive gains.

Great...when it works

That said, following the Fed isn’t always a guarantee of success for investors. One of the reasons for the intense focus on the Fed cutting interest rates for the first time in 4.5 years this September was that the last few rate-cutting cycles have corresponded with nasty bear markets. That’s not how the mantra is supposed to work!

In 2001, then again in 2007, the Fed embarked on significant rate-cutting cycles right into the teeth of bear market recessions that resulted in -50% losses for stock investors. (The 2019 rate-cutting cycle was less clear cut, as stocks initially rose before running into the COVID bear market four months after the third and final cut of that cycle.) With economic growth slowing in recent months, many are eyeing the 2001 and 2007 experiences as instructive of what may lie ahead.

The recession path vs. the non-recession path

Investors understandably want to know what “normally” happens when certain events occur, like the first rate cut of a cycle. But this is one case where the averages are highly misleading.

What one finds upon examining the data is that there are two distinct paths when the Fed embarks on a rate-cutting cycle: the recession path and the non-recession path. The outcomes have been starkly different since the Fed started announcing their target rate in 1980.

When the economy is heading toward (or already in) a recession, rate cuts are not helpful to the stock market, as can be seen in the table at right. Ignoring the opaque 2019 example, we find three such examples of this among the six rate-cutting cycles (following five or more increases) since 1980. The table shows the S&P 500’s maximum declines during the 12 months following the first rate cut.

On the other hand, when the economy avoids recession, rate cuts have provided the tailwind investors expect. The second table shows the maximum gains during the 12 months following the first rate cut in the non-recessionary cases.

Seeing those big moves — either up or down, with no middle ground — makes clear that recession is the key variable. Each of the three big losers lined up with a recession.

Are we on the recession path now?

Given the importance of this question to asset prices, it’s no surprise that there are many strong opinions circulating as to whether the economy is on a recessionary trajectory. It’s clear that the rate of economic growth has been slowing in recent months. But that’s different from the economy itself being slow.

One major challenge today is discerning which signals are evidence of a change in the economic cycle, versus what is simply normalization following the massive COVID economic stimulus.

Employment is a great illustration. After COVID, the labor market was incredibly tight, with extremely low levels of unemployment and job openings vastly outnumbering candidates. That is no longer the case today and, in fact, the unemployment rate has increased over the past 18 months from a low of 3.4% to 4.2%.

Those in the recession camp will point out that historically, there are very few cases when the unemployment rate has started to rise and not continued much higher as a recession ensued. But those in the non-recession camp counter that 4.2% is still a very low level historically, given the long-run average is 5.7%. Additionally, most of the increase in unemployment has been due to growth in the labor force (a positive sign) as opposed to layoffs.

In these respects, unemployment is potentially joining a list of other historically reliable recession signals (such as the Leading Economic Indicators and inverted yield curve that SMI has highlighted) that have failed as recession predictors for the first time in the current cycle. And that could be because this isn’t a normal economic cycle at all — it’s a normalization from an extraordinary economic experiment that is still reverting to equilibrium.

The Fed has shifted its focus

One thing that is clear is the Fed has shifted its primary focus away from inflation and toward supporting employment and the broader economy. That’s the only plausible conclusion for cutting the Fed Funds rate by 0.50% in September, despite economic growth (GDP) of 3.0%, with unemployment at just 4.2% and asset prices at all-time highs.

The asymmetry of Fed policy is striking. The Fed waited until March 2022 to raise interest rates 0.25%, when CPI was already running 8.5% annually. Yet today, with annual inflation still above their 2% target at 2.5%, they cut rates by 0.50%. Clearly, the Fed no longer fears inflation and has shifted its focus to warding off potential economic weakness.

That’s not necessarily inappropriate, as the Fed has a dual mandate to promote maximum employment and stable prices. But it does shift the risks somewhat for investors, as getting this decision wrong by cutting too much too soon opens the door for a resurgence in inflation.

Conclusion: Staying data dependent

The Fed likes to say that it is data-dependent. As their recent policy asymmetry shows, that’s debatable. But it’s a worthy goal and one that SMI actually practices through adherence to our trend-following and momentum-driven strategies.

At this point, there’s little concrete evidence to indicate the economy is at serious risk of slipping into recession. That doesn’t mean it won’t; it just means that the data isn’t yet indicating it is on that path. As was the case at the end of last year when many were calling for a recession, we’re inclined to think the economy will remain resilient for a while longer.

Most indicators still show a growing economy with few layoffs and low unemployment, so it makes sense to not fight the Fed as they purposely attempt to stimulate what appears to already be a reasonably healthy economy. There’s no question that high interest rates have suppressed some financing of homes, autos, and other durable purchases in recent years. So there’s potential for an improvement in the affordability of credit to potentially extend the current economic expansion.

But of course, the data could shift and reveal more economic weakness at any point as well. Rather than make a prediction on how this will all turn out, we’ll continue to monitor the data and make adjustments as economic conditions impact the market prices that drive SMI’s investing strategies.

Rate-cutting cycles represent big potential shifts in both the economic and market landscapes. As such, they’re worth monitoring for clues as to whether the future holds recession or inflation and whether the next 20% move in stocks will be higher or lower. Fortunately, we have tools to assist with that without having to predict in advance how an unpredictable economy will react months in advance.

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