While it must frequently adjust its predictions, the market yet anticipates two reductions in the Federal Reserve’s rates within the year. Should these occur, the implications for the S&P 500 are a matter of considerable speculation.
“At some point a kind of repetition creeps in, fatigue too, like over that eternal ECB watch, whether a comma has shifted somewhere. Take US interest rates. Do you remember whether or not it was raised in March 2018?”
That was what Lukas Daalder said to the Financieele Dagblad last week in response to a question about why he was calling it quits as chief strategist at BlackRock. Strategists, investors and others are nevertheless busy doing it: predicting what interest rates will do. Not infrequently in vain.
In January, the general expectation was that the Fed would cut interest rates by at least 150 basis points in 2024 from the 5.25 per cent to 5.5 per cent range. That those expectations were halved in the first quarter did not stop the S&P 500. The index is now trading more than 9 per cent higher than at the start of this year.
As of this week, most forecasters were putting their money on two interest rate cuts of 25 basis points in 2024, according to the CME FedWatch Tool. The first cut is likely to come this summer, still from the same range.
If the cuts do indeed come - a scenario with a 95 per cent probability at the time of writing - then there is reason for optimism. After all, the rule of thumb for equities is that prices rise when the central bank cuts interest rates. When exactly they come is a lot less relevant.
Interest rate cut and the S&P500
Peter Garnry, head of Saxo Strats, looked at the nine interest rate cut cycles since 1985 and found that the US stock market tends to rise mostly in the first three months after a rate cut cycle starts.
‘The average S&P 500 gain during the 90 trading days after an initial cut by the Fed was 5.1 per cent and that is significantly higher than the normal 3-month S&P 500 return which is between 2 per cent and 2.5 per cent,’ Garnry said.
Matt Weller, head of market research at trading platform Forex, takes a slightly different approach. He looked at 12-month periods after the start of the seven interest rate cut cycles since 1982 where at least 100 basis points were cut. Of the cycles studied, the S&P 500 was down three times (43 per cent) after one year.
According to his research, the S&P 500 rose an average of 4 per cent in the year before the Fed started cutting interest rates, and 7 per cent in the year after.
However, a larger dataset, which includes all interest rate cut cycles by the Fed since 1928 (22 of them), shows that the average return of US stocks is 11 per cent in the 12 months after the first interest rate cut. This is according to a study by Duncan Lamont, head of strategic research at Schroders. Interest rate cuts without recessions earned US equity investors an average of 17 per cent in the first year of the cut cycle, according to his analysis.
Three scenarios for the current cycle
If US inflation remains in line with the Fed’s forecasts, the bank is likely to start cutting interest rates before the end of the year. In that case, there are three possible scenarios for equity markets, according to Amélie Derambure, multi-asset fund manager at Amundi.
If the Fed cuts with clear signs of disinflation while the economy grows sufficiently (the “Goldilocks scenario”), both equity and fixed-income markets will do well, she tells Investment Officer. “Some sectors that have suffered more than others due to the rise in interest rates, such as construction and clean energy, are likely to experience a strong rebound.
If the Fed cuts interest rates several times while it is not entirely clear what will happen to inflation, while indicating that it will pause to assess the situation, it is likely to be relatively well absorbed by markets. ‘Equities will then behave depending on companies’ earnings cycles,’ Derambure says.
However, if the Fed starts a series of cuts with no prospect of a pause while it is still unclear what inflation will do, this will not be well absorbed by equity investors. If that happens, markets are likely to challenge the Fed and likely trigger a bear steepening scenario. That is not good for equities, Derambure said.
No panic
For now, many investors, including roughly all Wall Street banks, expect a good year for the S&P 500. The consensus is that the stock market will benefit from the Fed’s more accommodative monetary policy, even if the anticipation of it has already pushed stocks up.
Of course, if the cuts do not materialise, investors can always fall back on the only real rule of thumb for equities: those who wait long enough will see the price rise by itself.
S&P 500 vs US interest rate since 1980
Returning to Daalder, the Fed did indeed raise interest rates in March 2018. The policy rate was then raised by 25 basis points to the range of 1.50 per cent to 1.75 per cent. But as the ex-strategist rightly pointed out, “Do we really think the world would have looked very different today if that had taken place in May or June? No.”