Post-Fed Rate Cut

From summer to now, from stocks to bonds - global markets are all welcoming the news of the Federal Reserve's rate cut.

The Fed has been lagging behind many peers, before which, the central banks of the Eurozone, the UK, Canada, Mexico, Switzerland, and Sweden have all cut interest rates ahead of the Fed.

On September 18th local time, the Fed finally welcomed its first rate cut in four years, ending a four-year era of high interest rates.

The impact of this rate cut and the subsequent rate cuts on the economy and the stock market still needs time to prove.

The rate cut on September 18th local time was a foregone conclusion, as the Fed announced a 50 basis point cut to the target range for the federal funds rate, bringing it down to between 4.75% and 5.00%.

This is the first rate cut by the Fed in four years, symbolizing the end of an interest rate cycle.

Prior to this, to combat soaring prices, the Fed had raised the benchmark interest rate to 5.5% through 11 rate hikes, and inflation has fallen from a peak of 9.1% in June 2022 to 2.5%.

Fed Chairman Jerome Powell clearly stated in a high-profile speech in Jackson Hole, Wyoming, last month that Fed officials believe inflation has been largely defeated.

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The last time the Fed cut rates, the world looked very different.

That was in March 2020, against the backdrop of the COVID-19 pandemic causing global business to come to a standstill, the Fed initiated emergency rate cuts within weeks, reducing short-term borrowing costs to near zero.

It wasn't until the spring of 2021 that the Fed misjudged the situation, thinking that the sharp rise in inflation might be a flash in the pan.

Powell then shifted his stance at the end of 2021, first withdrawing stimulus measures, and then raising rates in March 2022.

Faced with inflation soaring to a 40-year high, the Fed quickly raised rates by an unusual 0.5 percentage points and 0.75 percentage points.

This was the fastest rate hike cycle since the early 1980s, and by July 2023, interest rates had risen to the highest level in 20 years.

Fast forward to this round of rate cuts, the situation has changed dramatically: now, the US labor market remains relatively stable, and inflation is cooling down.

"This is a decision that has been carefully timed, not an emergency wartime decision," said Dan North, senior economist at Allianz Trade.

Although this rate cut was a foregone conclusion, analysts had different views on the magnitude of the cut beforehand.

Many expected a smaller cut of 25 basis points.

Fed officials tend to make smaller adjustments, and this rate cut was stronger than expected, indicating that the Fed has become dovish, which puts it in a new phase of the inflation fight: the Fed is trying to prevent past rate hikes from further weakening the US labor market.

"We are committed to keeping the US economy strong," Powell said at a press conference, "This decision reflects our growing confidence that as long as we adjust our policy stance appropriately, the strong momentum of the labor market can continue."

The day after the Fed announced the rate cut, the three major US stock indexes all closed higher.

The S&P 500 and Dow both hit new historical highs again.

The Dow broke through 42,000 points for the first time, and the S&P 500 closed above 5,700 points for the first time, with the Nasdaq surging as much as 3% at one point.

Future rate cut expectations have strengthened forecasts show that the Fed will reduce interest rates to 4.4% by the end of this year, far below the 5.1% they expected in June, and officials expect to cut rates four more times next year, each equivalent to a 0.25 percentage point cut, provided that the unemployment rate does not jump and the inflation rate continues to fall.

In this way, by the end of 2025, the federal funds rate will be slightly below 3.5%.

However, some are worried that rapid rate cuts could reheat the economy and inflation could fall back into an uncomfortable high level again.

In recent weeks, some Fed officials have believed that the US economy is not weak enough to require a 0.5 percentage point rate cut.

Fed Governor Michelle W. Bowman voted against this rate cut, and Bowman is also the only Fed official to vote against it, she supports a 0.25 percentage point rate cut.

Bowman was appointed by Trump in 2018.

This is also the first time since June 2022 that the voting members have held different views.

Candidates from both parties also quickly responded to the Fed's actions.

"This news is good news for Americans who have been hit by high prices, and my current focus is on future work to continue to lower prices," said Vice President Harris, the Democratic presidential candidate.

In contrast, the Republican presidential candidate Trump's statement was more negative: "If they are not just playing politics, then cutting rates so much indicates that the economic situation is very bad."

Powell clearly stated at a press conference that if the economy proves to be weaker or stronger than expected, the Fed is willing to speed up or slow down the pace of future rate cuts.

Powell said, "The US economy is in a good position, and our decision today is to keep it there."

Although the Fed's rate cut has symbolic significance, economists and analysts say it is too early to declare that the Fed has achieved an economic "soft landing."

"Saying so now is like saying you have landed in the middle of a ski jump," said Gennadiy Goldberg, head of US interest rate strategy at TD Securities, "We are still in suspense."

What does it mean for the stock market?

Since 1929, the Fed has gone through 14 interest rate cycles, and how will the stock market perform when the Fed starts to cut rates?

Investors often ask such questions.

The general view is that rate cuts are good for the stock market, but unfortunately, there is no simple and unified answer to this question.

Especially this year, there is still a lot of uncertainty about the expected rate cuts and the November presidential election.

The Fed lowers interest rates to stimulate the economy, which is often beneficial to stocks.

Sometimes it is.

Take the S&P 500 as an example, it has performed well after many first rounds of rate cuts.

Charles Schwab said that in the past 14 interest rate cycles, the S&P 500 has recorded positive returns 12 times within 12 months after the first rate cut.

The only two negative return periods occurred after the Fed cut rates in 2001 and 2007, the former during the burst of the internet bubble, and the latter during the subprime crisis.

However, strategists say that investors should observe more carefully, especially in today's unusual environment, "It is necessary to understand that each cycle is different."

It is worth noting that studies have shown that "defensive" industries, that is, those that are more likely to resist economic uncertainty, such as healthcare and utilities, usually perform well when interest rates rise.

On the contrary, "cyclical stocks" - industries that benefit from economic acceleration, such as non-essential consumer goods and industry - have greater potential when interest rates fall.

Analysis by research firm Ned Davis Research shows that cyclical stocks usually perform best when the Fed enters a gradual rate-cutting period.

It is worth noting that the definition of defensive and cyclical industries themselves will change over time.

For example, technology stocks have always been considered cyclical stocks, but in this round of the Fed's tightening cycle, large technology companies have many characteristics of defensive companies, and the large amount of cash held by technology companies (as well as other factors) has made them immune to higher borrowing costs and has successfully outperformed the market.

Technology stocks are also expected to be boosted by this round of rate cuts.

Analysts at the well-known US investment bank Wedbush said that the current market is relatively moderate, coupled with the boom in technology spending brought by artificial intelligence, will create ideal conditions for technology stocks, and technology stocks will rise before the end of this year and before 2025.

Even if the Fed's decisions will have a certain impact on the stock market, each rate cut cycle is different, and monetary policy is not the decisive factor in the success or failure of the stock market.

The stock market will change with economic fundamentals, investor sentiment and other factors, and the reaction of the economy brought by rate cuts is both long and variable.

As American economist Milton Friedman said in a speech to Congress in 1959, at that time, he compared changes in Fed policy to - "You turn on the faucet now, and then it starts to run after six months, nine months, twelve months, sixteen months from now."

The changes caused by this round of rate cuts have just begun.