The long-awaited Fed policy shift is finally on the way. Last Friday, Federal Reserve Chairman Jerome Powell said in a speech at the famous Jackson Hole Economic Symposium that “it is time to adjust policy,” clearly hinting that the U.S. will cut interest rates at the FOMC meeting scheduled for September. Stock and bond markets rejoiced, as they always do.
Over the past 25 years, there have been three interest rate cutting cycles in the US and the initial reaction on the eve of the first rate cut was always positive. But as the rate cutting cycles continued, what was the follow-through? Here we consider how different asset classes and key macro indicators performed during past rate cutting cycles (see also table) and the lessons for investors. The analysis considered the changes from the month of the first rate cut of the cycle to the month of the last rate cut.
An analysis of what has happened since the rate-cutting cycle began offers the message that we should be careful about what we wish for (lower interest rates).
Glass half full?
With the rate-cutting cycle underway, the battle is only half won: victory over inflation can only be declared once the economy has achieved a soft landing, which will not become clear until sometime next year.
The last three times the Fed cut rates, the U.S. economy ended up in recession. Even in 2020, when the coronavirus pandemic triggered the economy to slow, many rate-cutting cycles before that led to recessions. Soft landings are rare, but were achieved once during the mid-1990s cycle.
Each cycle had different dynamics: in 2000, the economy/market was already starting to weaken/adjust before the rate cut, whereas in 2007, the economy/market continued to strengthen/rise for a few months after the rate cut, resulting in the economy/market going through tough times during previous rate cutting cycles for various periods of time.
During the 2001-2003 rate-cutting cycle, the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite fell 17, 32 and 34 percent respectively, while the Nifty 50 fared better with a mere 10 percent decline. India too had a tough bear market during this cycle, but a recovery phase began in early 2003. Conversely, all four indexes experienced a 30-40 percent correction at the time of the final rate cut during the September 2007-December 2008 rate-cutting cycle, but the pain continued even afterwards.
Gold has performed well throughout these cycles, generating strong returns in dollar terms and even stronger returns when considering the depreciation of the Indian rupee (USDINR) in the 2007-08 and 2019-20 cycles.
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Related article: US Federal Reserve keeps interest rates on hold, plans only one rate cut in 2024
How should investors position themselves?
A soft landing remains possible, but investors must view it as far from certain.
Given this, hedging your portfolio by increasing your allocation to gold and bonds may be a good move. Apart from this, investors should closely track the development of the US unemployment rate in the coming months. When investors try to analyze why the interest rate cut cycle has had a negative impact on the overall market, one of the data points to check is what factors are triggering the rate cuts.
Rising unemployment is a factor that influences the start of a rate cutting cycle as the US Fed tries to balance its dual mandate of price stability and maximum employment. This time around, no different, the July unemployment report triggered the Samrull Recession Indicator. Rising unemployment impacts spending in the consumer-driven US economy, triggering an economic slowdown/recession with ripple effects on economies and markets around the world.
