A look at previous Fed rate cuts and what it means for equities

Initial rate cuts are rarely seen as negative

Since 19 October the market has drastically altered its view on inflation and more importantly policy rates set by the Fed and ECB. As the US SOFR (Secured Overnight Financing Rate) Dec 2024 contract is showing the market has moved the 2024 terminal Fed Funds rate lower by almost 100 bps. This repricing has fuelled sentiment in equities delivering one of the strongest months in 20 years in equities. The SOFR futures forward curve is now pricing in 5 rate cuts by December 2024 with the Fed rate cut coming at the Fed meeting on 20 March.

There have been 9 initial Fed rate cuts starting a rate cut cycle (shorter or longer) since 1 January 1985 and if we look at the S&P 500 performance during these periods then the US equity market tends to rise in the subsequent 3 months after a rate cut cycle has begun. Remember that with only 9 rate cut cycles the statistics here come with small confidence and investors should take note of the current situation instead of blindly trust history. The average S&P 500 gain during the 90 trading days after an initial Fed rate cut is 5.1% which is significantly above the normal 3-month S&P 500 return which is in the 2-2.5% range.

History gives us the clue that an initial rate cut by the Fed is often interpreted by the market as a natural initial adjustment of policy rates to changing circumstances. But the market is rarely coupling the initial rate hike with an incoming recession. If that was the case history would a more clear downward direction in equities post an initial rate hike. This is also likely the reason why equities have rallied since mid-October. The equity market sees the current priced in rate cuts as a natural adjustment to lower inflation and not a sign of a recession. Should SOFR futures suddenly rally a lot higher from here then it would be a sign that rates traders are seeing a recession coming and then the interpretation by equities will flip on dime.

Another striking difference in the market is the median recession probability by economists tracking the US economy. The probability is at 50% which is a huge divergence from equity markets which are closer to all-time highs and thus signalling less than a 10% probability of a recession.