On July 31, 2019, the Federal Reserve cut interest rates for the first time since the Great Recession in 2008, while also leaving the door open for further interest rate cuts. By doing so, the Fed has signaled willingness to help stave off a potential economic downturn (recession), which investors have been fearing, largely due to uncertainties caused by the US-China trade war.
Every time the Federal Reserve starts a new cycle of interest rate cuts or hikes, market watchers warn “Don’t fight the Fed.” What does that old investing adage mean? It suggests that investors are wise to invest in a way that aligns with the current monetary policy of the Federal Reserve, rather than against it. This is because the market tends to rise when the Fed is cutting interest rates, and tends to fall when the Fed is increasing interest rates. There are many reasons for this relationship. One of the main reasons is that lower interest rates mean that bonds and GICs are less attractive to investors. For example 1-5 year GICs are currenlty paying, on average, around 2%, 10-year Government of Canada Bond yields are around 1.3%. Given these low rates, even if retail investors are willing to buy only bonds and GICs, institutional investors (e.g. pension funds like the CPP) are forced to diversify into stocks, in order to generate reasonable returns for future pensioners.
Has the relationship worked? The above chart from LPL Research shows the performance of the S&P500 after the last seven instances when Fed rate cuts took place after at least one rate hike. Of the seven instances, five saw equities generate solid gains 6 months and 12 months following the initial Fed rate cut. The most recent instances (January 2001 and September 2007) saw stocks fall after the initial rate cuts. Why? We believe that whether a rate cut leads to a positive or negative outcome for equities depends on whether a recession is actually around the corner. The rate cuts in the two most recent instances happened right before recessions (2001 was the year of the 9/11 attack, and 2007 was the real estate bubble in the US/global financial crisis).
Which scenario will play out this time around? Whether cutting rates will lead to an extension of the bull market depends on whether the Fed is behind the curve, or ahead of it (in other words, whether or not a recession is around the corner). Because it takes time for the effects of interest rate cuts to appear in the economy, it is very important for the Fed to be ahead of the curve. Although U.S. recession risk has increased in recent months amid renewed trade tensions and an inverted yield curve (10-year Treasury below 2-year Treasury), most of our U.S. recession risk gauges continue to signal that the economic expansion remains intact (for example, the US unemployment rate is the lowest it has been in 50 years, at 3.7%). Therefore, cutting the interest rate now is seen as a preemptive move aimed at extending the record-long economic expansion.
In summary, we believe that the “Don’t fight the Fed” philosophy will likely work this time around!