Investors are puzzling over the apparent paradox presented by the combination of stocks trading at or near all-time highs and a Federal Reserve that appears ready to deliver an imminent rate cut.
Read: An economy gone ‘mad’? The Fed is going to cut rates despite record stock prices, low unemployment
A look back at history shows that the Fed has been willing to cut rates with stocks at or near all-time highs in the past, but it’s a phenomenon that hasn’t been seen in more than 20 years. Market analyst Charlie Bilello last week noted on Twitter that since the Fed started targeting the fed-funds rate in 1982, it has delivered rate cuts with the S&P 500 SPX, +0.04% at an all-time high seven times — the last such cut occurring in January 1996.
Since the Fed started specifically targeting the Fed Funds Rate in 1982...
1) It has cut rates w/ the S&P 500 at an all-time high 7 times, last in Jan 1996.
2) It has never cut rates w/ the Unemployment Rate below 4%. Lowest unemployment rate w/ a rate cut was 4.2% in Jan 2001. pic.twitter.com/wTN5euriBF
— Charlie Bilello (@charliebilello) July 11, 2019
Fed-fund futures show traders see a 100% probability of a rate cut when policy makers meet July 30-31. Meanwhile, the S&P 500, the Dow Jones Industrial Average DJIA, +0.01% and the Nasdaq Composite COMP, +0.12% posted record finishes on Monday, building on all-time highs scored in the wake of testimony last week by Fed Chairman Jerome Powell that offered no pushback against rate-cut expectations.
See: Powell’s testimony leaves Fed watchers scratching their heads
Meanwhile, Ryan Detrick, senior market strategist at LPL Financial, which has around $684 billion in advisory and brokerage assets, found that the Fed cut rates 17 times since 1980 when the S&P 500 was within 2% of its all-time high. He also observed that the index was higher a year later all 17 times, with a median gain of 10.4%.
Can the Fed really cut rates with stocks at new highs?
Going back to 1980, they've done it 17 times (SPX within 2% of new highs).
A year later? The S&P 500 was higher all 17 times. pic.twitter.com/9YSBOVhfeI
— Ryan Detrick, CMT (@RyanDetrick) July 11, 2019
The first ‘insurance’ cut?
Of course, as the old saying goes, the stock market is not the economy. But, as Bilello noted, a rate cut at the Fed’s July 30-31 meeting — as is widely expected — would mark the first time the central bank has ever lowered rates with the unemployment rate, which stood at 3.7% in June, running below 4%.
So, if the Fed does follow through on overwhelming expectations, it might mark what Jeffrey Schulze, investment strategist at ClearBridge Investments, which has around $142 billion in assets under management, argued would be the first true “insurance” cut by policy makers.
Also read: Should investors prepare for a ‘shock and awe’ campaign from the Fed?
While a number of investors and analysts have described easings in 1995 and 1998, when rate cuts were not followed by recessions, as past insurance moves, Schulze noted that in those cases, the Fed moved after a drop in the Institute for Supply Management’s manufacturing gauge to a reading of less than 50, which signals a contraction in activity.
“If the Fed actually does the cut in July this year, I think this will be the first insurance cut, if you will,” Schulze said, in an interview.
The ISM manufacturing index has been under pressure, falling to 51.7% in June and signaling the slowest pace of expansion for the sector in more than two years. Powell cited the fall in the indicator as he highlighted worries about the economic outlook in his congressional testimony last week.
Motivations
Some market watchers have tied the Fed’s aggressively dovish tilt to President Donald Trump’s steady stream of criticism of the central bank and Powell. Trump has argued that the Fed’s previous rate increases have left the U.S. economy at a disadvantage and has said policy makers should cut rates and resume quantitative easing.
Rex Nutting: Trump and the stock market are spooking Powell into making this rookie mistake
Others have argued the central bank is taking a cue from financial markets.
“With growth having yet to deteriorate in any significant way — again, we look to be on the precipice of getting a 4% real consumer growth print for 2Q — we are no longer talking about a soft landing approach here, but rather supporting an above-potential economic backdrop,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets, in a note.
“What’s more, a quarter-point cut or two in the fed-funds rate carry little potential cost and carry the benefit of appeasing financial markets,” he said.
“Perhaps the reaction function is as simple as that. In an economy that remains defined by strong household balance sheets, continued de-levering, high savings, high confidence, and rising wages, the risk of an unsustainable debt-fueled bubble seems quite low,” Porcelli said.
Testing times
Schulze, meanwhile, argued that the Fed is right to pay attention to fears of a slowdown. ClearBridge’s internal recession indicator has turned from green to yellow, signaling a 50% chance of recession. While markets tend to rise in the immediate wake of a yellow reading, he sees a “high likelihood” of a 5% pullback for stocks in the next three months.
For now, however, the equity market’s reaction to the Fed’s dovish shift is unsurprising. “Whether you go into recession or whether it’s one of these false positives like you saw in ‘95 or ‘98, rate cuts are always rewarded by the market initially,” Schulze said. “That’s the initial euphoric reaction, and I think you’re seeing that today.”
An important test might come in the third or fourth quarter, he said. A continued deterioration of global macroeconomic data and a weakening of U.S. stocks would likely see investors become more alarmed over the threat of a recession, potentially leading to another 5% to 10% pullback.
Related: Why Citi’s top stock-market analyst is worried about a second-half ‘soft patch’
