A HISTORY OF FIRST CUTS

2018-11-26 2pm EDT  |  #stocks #Federal Reserve

The market is definitely torn about whether last week the Federal Reserve signaled a pause in their rate-tightening campaign. You know where I stand (they did), so there is little to be gained by my shouting into the wind trying to convince anyone.

Yet one of my more astute readers sent a note to be careful what I wish for. Now, he knows we are a long way from the Fed actually cutting rates. In fact, I suspect we both think the Federal Reserve will raise rates this December. But let’s imagine that I am correct and the next meeting brings about a one-and-done rate rise. What if the Fed’s next move after December is a rate cut? I know that seems preposterous right now, yet there are many signs the American economy is slowing faster than the Federal Reserve forecasts.

Regardless of where one stands in regards to future monetary policy, it’s instructive to examine the stock market’s performance around Fed rate cuts. Whether the next cut is one quarter away, one year, or even one decade (for those hard money advocates who believe we need to really normalize rates…), at some point, the Federal Reserve will once again lower rates. Understanding how the stock market has reacted to this development in the past is a good arrow to have in your quiver.

So here’s the deal. The answer is… it’s complicated.

The past two Federal Reserve rate cut cycles have indeed seen the stock market fall extensively during the Fed’s easing of monetary policy.

Let’s go through them one by one to get a feel of what they looked like, starting with the most recent Fed cutting cycle:

Did the Fed’s easing come charging to the rescue and save stocks?

Unfortunately not.

The stock market was about to pick its head up off the mat during the first month after the cut, but then it melted for the next year - irrespective of how aggressively the Federal Reserve cut rates.

Well, that’s pretty depressing. But that was the Great Financial Crisis. It was a unique period. What about the previous Fed rate cutting period? How did the Fed handle the bursting of the DotCom bubble?

Surely easy-Al saved the stock market with all his cuts?

Ooops. Another terrible stock market performance following the first rate cut.

This phenomenon of the first Fed rate cut, far from being the stock market’s saving grace, but rather the start of a protracted bear market, is why my reader pal warned that the Federal Reserve going dovish might be more of an omen than good news.

Yet has it always been this way?

Let’s keep digging. Next rate cut was the Long-Term-Capital-Management-crisis.

What happened to stocks during this Fed rate cutting campaign?

Now there’s a different picture! The first month saw stocks sag, but within no time, they were in the green and pushing higher.

What’s different? Why did stocks respond so much better to the Fed’s cutting rates this time?

Maybe it has something to do with the amount of raises going into the cuts. After all, 1997 only saw one rate hike before the cutting cycle kicked in.

Let’s look back even farther to 1995. That looks more like a normal cycle.

OK, the Fed Funds tightening looks more typical than 1998, so how did stocks perform when rates were cut this time?

Whoa! Looks more like 1998 than 2001 or 2007. Although stocks treaded water for the first couple of months, they then took off like they stole something.

We’re now even for stock market reactions to the first rate cut (2007 and 2001 with negative reactions while 1998 and 1995 saw positive responses), so let’s go back even farther into the archive.

Next up - the 1989 easing cycle.

Looks like a classic. The Federal Reserve took funds up for most of 1988 and then realized they had gone too far and proceeded to cut in 1989.

What was the stock market reaction?

Kind of in-between. A little initial weakness and then some strength, but nothing to write home about.

Next up - the infamous Black Monday! The 1987 equity crash caused the newly appointed Federal Reserve, Alan Greenspan, to take back the recent hikes and cut rates.

Did the Fed stop the crash? Did stocks rally when they cut rates?

Not initially. Stocks went down 10% before rallying more than 25% off the lows during the rest of the year.

One last cycle before we try to come to some conclusions - 1984 in an interesting one.

The Latin American crisis occurred during Fed Chairman Volcker’s tenure. He had initially raised rates in 1984, but was then forced to almost halve the Fed Funds rate during the ensuing debacle.

That’s some pretty aggressive easing. How did stocks respond?

Although it took a full quarter, eventually the rate cuts did the trick.

Rate cuts are not some magical elixir

Bringing it back to some actionable trading ideas, what conclusions can we draw from the history of the first Fed Funds rate cut?

Well, I agree with my reader who warned to be careful about wanting a dovish Federal Reserve. During the last two cycles, by the time the Federal Reserve had actually gotten around to cutting, it was much too late for the stock market. Equities proceeded to sink well after that first cut and the lesson turned out to be how vulnerable stocks were to a deflationary feedback loop.

Here is my theory. The Federal Reserve is a backward looking entity. They are trying to tune an economy by setting monetary policy based on economic indicators from months and even quarters ago. Yet the real problem lays in their unwillingness to upset the market.

This reluctance to surprise market expectations means they move rates much too slowly. They take too long to raise rates, thus encouraging too much speculation, and then when it inevitably collapses in on itself, they are equally slow to lower rates until a self-reinforcing negative feedback loop is firmly entrenched. Which paradoxically means they need to cut rates even lower than would otherwise be the case.

So here we are again with the Federal Reserve having taken years to raise rates to this level. And the real question to ask ourselves is will the Fed make the same mistake again?

Will the Fed simply leave the rate tightening campaign on slow-cook, hiking slowly until it’s finally too late and the speculation comes unwound in a massive sickening whoosh? And if so, have we already passed the point of no return? Is it long past the time when the Fed can get out ahead of this disaster-in-the-making?

I am not sure. But I do have one observation for you. Look closely at the performance after the first cut in the examples above. Was there ever a time when the Fed cut rates and stocks screamed higher immediately? Nah. Not a chance. Stocks are a sell on the first cut. At least for a month of two. To me, that’s the real lesson.

Thanks for reading,
Kevin Muir
the MacroTourist

East West Investment Management
Global Select Opportunities Fund