Equities and Treasuries Historic Rate Cut Reactions

Michael Normyle – Nasdaq’s US Economist joins IBKR’s Jeff Praissman to discuss the stock market and Treasuries historical reactions to rate cuts.

Summary – IBKR Podcasts Ep. 193

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi everyone, I’m Jeff Praissman. It’s my pleasure to welcome back to the IBKR podcast studio for our monthly podcast on the economy, Nasdaq’s U. S. economist, Michael Normyle. Michael, how are you? 

Michael Normyle 

Hi, I’m doing great. Thanks. 

Jeff Praissman 

Michael and Nasdaq are frequent contributors to Interactive Brokers educational series’, whether it’s podcasts, webinars, or articles. All their contributions can be found on interactivebrokers.com under the Education tab.  

And today, we’re going to talk about something that’s on everyone’s mind after the Fed’s actions rate cuts. Michael, is a Fed rate cut always a sign of economic weakness? 

Michael Normyle 

Yeah, I think it’s safe to say that’s at least almost always the case, right? So oftentimes the Fed is cutting rates in response to a recession. In the best case, the Fed manages to pull off a soft landing, which is still cutting rates in response to a slowing economy but preventing a fall into recession. 

I think in the current scenario, the Fed ratcheted up rates to cool down demand and slow inflation. We’ve seen CPI inflation come down from a peak of 9.1% to just 2.5% now. But lately, we’ve also seen the labor market weaken too, which we talked about last month in our discussion of the Sahm rule. 

So now, the labor market has softened to a degree that Fed Chair Jerome Powell said in his annual Jackson Hole speech in August that the Fed does not seek or welcome further cooling in labor market conditions.  

So, the Fed is now cutting rates to forestall further labor market deterioration in hopes of achieving that soft landing. 

Jeff Praissman 

Really probably, at the end of the day, our listeners really want to know, when the Fed cuts rates, does the stock market always react the same way, or can it react in different ways? 

Michael Normyle 

Yeah, it doesn’t react the same way. And of course, there’s always some unique set of circumstances around each rate cut cycle, but it really boils down to whether the economy avoids recession or falls into recession. And that’s because a recession, it’s a vicious cycle of contracting economic activity, whereas a soft landing, it’s still an economic expansion, just that the pace of economic growth has slowed while staying positive. 

So the impact on demand, margins, and companies is really different under both scenarios. 

Jeff Praissman 

So let’s start with expansions because I like to keep it positive here. So how do equities react during rate cuts that happen during expansions? 

Michael Normyle 

Yeah, equities tend to do well during rate cuts that coincide with expansions, and that makes sense, right? Lower rates, they’re good for equities, they boost valuations, they reduce borrowing costs, and so that’s all good for increasing margins. And that’s especially true for growth stocks, where earnings are expected farther out in the future. 

Plus, you’re getting rate cuts that help boost demand for an economy that’s already expanding. So all around, it’s a good setup for stocks. 

Jeff Praissman 

So it snowballs on itself and keeps building up, where the economy is naturally going anyway, and then just rate cuts give a little bit of a boost, it seems, during the expansion.  

So layman’s terms, if we could dive a little bit deeper, though, into the, historic performance of equities during rate cut cycles during expansions, let’s say maybe like the past fifty years or so, after the rate cut, the initial rate cut, I should be more specific, how have they performed like the first three months, the next six months, and then one year after that initial first cut? 

Michael Normyle 

Yeah, so research shows that in the first three months after the Fed starts cutting rates, S&P 500 saw a total return of 11% during expansions. After six months, it’s up over 16% on average. And after a year, it’s up close to 20%. And so that’s roughly double the long run average total return for the S&P 500. 

So 20%, it’s well above the average annual return. But of course, as a NASDAQ employee, I have to say the returns are even stronger for the NASDAQ composite at over 25%. Of course, this is all historical performance. But that’s what we’ve seen in the past. 

Jeff Praissman 

And, besides for equities, how about treasuries? Do they react positively or negatively during a cut in expansion? And how do they perform during the same time periods that you just discussed- the three month, the six month, and the one year after that initial cut? 

Michael Normyle 

Yeah. Treasuries, they’ve reacted positively, historically, to rate cuts and that’s because prices for bonds rise as rates fall and vice versa. So if I buy a bond before the Fed starts cutting rates, then my bond becomes more valuable as rates fall, since it has a higher fixed rate relative to prevailing rates. 

And so if we use the Bloomberg US Treasury Index, that looks at treasuries with durations longer than a year. And those saw a total return of about 3.5% after three months, 4.5% after six months and almost 8% after a year. So all positive returns, but less than half with S&P 500 managed. 

Jeff Praissman 

So let’s pivot right back to equities again and rate cuts, but this time I’d like to talk about what happens during a recessionary period. Do they perform the same way as they did in an expansion period? And then going back to the same first three months after that initial rate cut, the first six months and then the one year after the first rate cut, just give our listeners sort of both sides of the coin. 

Michael Normyle

Yeah. So research from Franklin Templeton shows that in the short run equities don’t do well during recessions. And again, that makes sense, right? The economy, it’s contracting. That hurts demand. So, that’s going to be bad for sales for companies when they’re reporting earnings and all of that stuff. 

So over three months, the total return for the S&P 500 is -1.5% but, since markets are forward looking, they tend to rebound before the recession is over. So by six months, they’re up over 2%, and by a year, they’re up nearly 10%. So about half of the return that we got for expansions. 

Jeff Praissman 

So really in the long-term, rate cuts will help, no matter what kind of period we’re in, whether it’s expansion or recessionary.  

If the investor is taking a long-term view, generally speaking, the equities will increase. It’s just really that short term initially after the cut that depends on, from historical data, what we’re going through, whether we’re going through a recessionary period or expansionary period. 

Michael Normyle 

Yeah, on average, right? 

Jeff Praissman

And how about treasuries? During a recessionary period, are they seeing negative returns as well? Are they following suit with equities in that case? Or are they seeing positives in that three months, six months, one year after the first cut period? 

Michael Normyle 

Yeah, actually, no, they don’t see negative returns. So after the first rate cut in cycles associated with recession, treasuries, they’re up almost 2% in the first three months, and then almost 7% after six months. And over 10% after a year. So that means at the six month and one-year marks, treasuries actually did better during recessions than expansions. 

And so that makes sense when you think that during recessions, you’d expect the Fed to be cutting rates more and faster than during non-recessionary rate cut cycles.  

So the value of bonds issued prior to rate cuts becomes relatively more valuable in that scenario. And so that helps explain why you often hear people talk about bonds as something that’s historically used to diversify a person’s portfolio. 

Jeff Praissman 

And, now let’s hop back to equities, but I’d like to talk about different regions. I mean, the world’s a big place. Yeah, it seems small every day with how everything’s connected. 

Our listeners are worldwide. NASDAQ’s got footprints in various countries as well. Your exchanges. 

Break it down by a couple of different regions. And I’d like to start with Japan, first of all. How does Japan react to rate cuts? I guess the Japanese market is really what I mean. 

Michael Normyle 

Yeah and to Fed rate cuts, those actually matter for equity performance around the world too, since it’s the central bank that governs the largest economy in the world. And so for Japan, we’ve seen that a year after the first Fed cut, the MSCI index of Japanese equities, it’s up about 23% on average during expansions. 

But when we see those Fed rate cuts during U.S. recessions, the Japanese MSCI index is down about 2% after the first three months, but ended ends the year up about 1%. So that follows the same kind of down than up pattern that we saw in the U.S. 

Jeff Praissman 

And what about the emerging markets? Brazil and other markets that people are so in tune with these days as well. 

Michael Normyle 

Yeah, the results, they’re a bit different. They’re not following the same pattern that we saw with the US and Japan. Of course, in expansions, the MSCI Emerging Markets Index is up gaining 27% in a year on average, but for recessions, they’re actually we’re up 1% over the first three and six months, but then they ended the year down 8% on average. So a kind of up and down pattern instead of the down and up pattern that we saw with recessions in the U. S. And then Japan’s reaction to recessionary Fed cuts as well. 

Jeff Praissman 

And finally, Europe. How does the European market react? 

Michael Normyle 

So again, it goes back to following the pattern that we saw with the U.S. and Japan, where we have that down then up move for those recessionary Fed cuts. MSCI Europe was down 2% on average after three months but finished the year flat. Not seeing the same positive numbers that the U.S. and Japan saw, but still recovering from those initial sell offs. 

And for expansions, MSCI Europe was up about 20% after a year. 

Jeff Praissman 

This was great, Michael, by the way, and super informative. Any final thoughts you’d like to leave the listeners with regarding rate cuts in the economy and the markets? 

Michael Normyle 

Yeah, I think the takeaway here really is, historically, when the Fed manages to pull off a soft landing, that’s the best outcome for equities. And right now, with the economy, it’s in solid shape, but it’s slowing. So, there is still hope that the Fed can manage a soft landing this time around, but we’ll have to wait and see if these cuts are enough to preserve the strength that we’ve seen in the economy to date. 

Jeff Praissman 

Thanks again for stopping by the IBKR podcast studio. I really look forward to our monthly chats and I’m especially looking forward to next month’s podcast when we revisit a subject we did earlier in the year the election economy. 

Michael Normyle 

Yeah, a lot’s changed. 

Jeff Praissman 

Yes absolutely. And again, a reminder for our listeners that this podcast can be found on our website, on Spotify, Amazon Music, Google Music, Apple Music, and so forth, on YouTube. 

And all our great past material that we’ve collaborated with NASDAQ and all our other collaborators is found on our website under the Education tab. 

You can go right to Podcasts, Webinars, Articles. Look for Contributors. You can find NASDAQ and see all the great educational materials they’ve contributed with us.  

Michael, thanks again. It’s always a pleasure. 

Michael Normyle 

Yeah. Thanks. 

Go Source