As the Federal Reserve prepares to cut interest rates for the first time in four years, traders are looking back to 1995, when Alan Greenspan led the Fed to a rare soft landing, to develop their current trading strategies.
As they did nearly three decades ago, U.S. bonds and stocks rallied ahead of a key Federal Reserve meeting. But this time, the central question facing Fed Chairman Jerome Powell is which approach — a 25 basis point rate cut or a 50 basis point one — is best for the U.S. economy.
In the view of Kristina Hooper, chief global market strategist at Invesco, the U.S. economy looks set to avoid a recession as the Federal Reserve begins to ease policy ahead of the U.S. election.
“Once the Fed starts cutting rates, it will trigger a psychological reaction and that will be a positive factor,” she said.
The S&P 500, U.S. Treasuries and gold typically rise when the Fed starts cutting interest rates, according to a Bloomberg News market analysis of the Federal Reserve’s six easing cycles since 1989.
In the stock market, the S&P 500 has risen an average of 13% in the six months after the Federal Reserve began cutting interest rates, with the exception of the 2001 and 2007 recessions, the data showed.
Meanwhile, short-term Treasury bonds typically outperform longer-term bonds during the Fed’s easing cycles, a phenomenon known as yield curve steepening. Six months after the Fed’s first rate cut, the gap between 10-year and 2-year Treasury yields typically widens by an average of 44 basis points.
In addition, gold has delivered returns to investors in four of the past six easing cycles by the Federal Reserve. The dollar and oil have been mixed.
How asset classes performed one year after the first Fed rate cut
Of course, traders are far from certain about the economic outlook in the coming months.
The Federal Reserve will begin cutting interest rates before former President Donald Trump and Vice President Harris face off in the November election. The two presidential candidates have proposed starkly different economic agendas, but both have the potential to roil global markets depending on how Congress votes.
“A soft landing is the most likely scenario. But the election will be important and this could be a unique cycle,” said Salman Ahmed, head of global macro and strategic asset allocation at Fidelity International. He has downgraded U.S. stocks to neutral from overweight, in part because of election risk.
Republican candidate Donald Trump has pledged to impose high tariffs and extend tax cuts, a policy combination seen as bullish for the dollar and bearish for bonds. Economists at Goldman Sachs Group Inc. said Trump's tariffs, if implemented, could fuel inflation.
The former president promised to cut the corporate tax rate from 21% to 15%, which would be a boon to corporate profits. By contrast, his Democratic rival Harris has proposed raising the rate to 28%, which would reduce corporate earnings by about 5%, according to Goldman Sachs economists.
A script or rerun of 1995?
In the past six easing cycles since 1989, the Fed has only managed to avoid a recession twice - in 1995 and 1998. The U.S. stock and bond markets expect the Fed to achieve a 1995-style soft landing this time as well.
Back then, Greenspan and his colleagues cut interest rates from 6% to 5.25% in just six months, saving the economy from recession. In the 12 months after the first rate cut, Treasury yields closed higher, while total returns on bonds lagged behind those on cash.
This time around, Fed officials have kept their benchmark interest rate in a target range of 5.25% to 5.5% for 14 months, though policymakers have stopped short of promising aggressive rate cuts.
Bond traders expect the Federal Reserve to ease by more than 200 basis points over the next 12 months, the S&P 500 is just one step away from its all-time high, and credit spreads are near record lows.
What has given investors hope for a soft landing is that household and corporate balance sheets are strong. Corporate profits and household wealth are at historic highs, making them less vulnerable to economic shocks.
“The big problem facing the economy and the stock market is no longer inflation, but high interest rates,” said Yung-Yu Ma, chief investment officer at BMO Wealth Management. “By cutting rates now, the Fed may be able to address that problem and prevent a recession.”
That has traders positioning themselves for lower borrowing costs and a relatively resilient economy.
The latest stock flow data released by Bank of America and EPFR Global showed that funds were flowing into the utilities and real estate sectors, two key sectors closely related to the economy that have historically benefited from interest rate cuts as long as economic growth is strong.
Bloomberg Markets Live strategist Tatiana Darie also pointed out that traditionally, U.S. Treasuries rebound at the beginning of the Fed's easing cycle, which usually coincides with economic weakness. However, in the case of a soft landing, bonds tend to lag behind stocks.
Article forwarded from: Jinshi Data
