FED Pause vs FED Cuts

Stocks are at a major inflection point between a bear market and a bull market environment. The S&P500 has been trapped in a trading range for months right at the half-way point between its all-time high and a major bear-market low in October 2022. There is a reason stocks are stuck here in a mind-numbing grind sideways: The economy right now is doing much better than anticipated by a majority of investors, but the specter of a recession in the near future is threatening.

By looking closely at the data around past FED interest rate hike cycles, we can gain valuable insight into the uncertain path of the current economic cycle, as well as the most likely impact on the stock market. How this cycle plays out hinges on a complex interplay between inflation, interest rates and the economy’s resilience. All of these factors are very difficult to forecast, but right now we are at an unusual point in time when the path of the FED’s interest rate policy is uncommonly clear: We are likely to have reached an interest rate plateau, which is usually followed by rate cuts. (For this analysis it is secondary, whether another 25bps rate hike is in the cards or not.)

In common lingo this process is often thrown together into the term FED Pivot, which is perceived to be positive for equities as liquidity conditions improve through falling interest rates. However, it is important to differentiate between its stages, as well as view today’s cycle as conditional to a high inflation environment.

**A majority of investors expects a recession, and there is a high probability to encounter a significant stock market low roughly in the middle of it.**

The Interest Rate Plateau

This is one of the most secure forecast we can currently make: The FED has paused its rate hike cycle and now aims to keep interest rates high and steady for as long as possible. Historically such pauses have lasted between 6 to 14 months and, while impossible to predict, I expect a longer-than-average halt in the current environment. High inflation constrains the FED from actually cutting rates unless we see very serious problems in the economy – until something breaks. The ongoing saga of the banking crisis shows this clearly, because in past decades such a crisis would have been more than sufficient reason to begin cutting rates.

A long FED Pause with interest rates at a high level will put a lot of pressure on a resilient economy. This is actually the FED’s goal, as it’s the only way it can bring rampant inflation down. The consensus among market participants is that the US economy will eventually collapse under rising pressure and fall into a deep recession, as the effects of higher cost of capital filter through the system. However, the last months show that that’s by no means a given – at the very least economic resilience can last much longer than investors and analysts expect.

**In the last decades, the S&P 500 index has produced an above-average return one year after the end of a rate-hike cycle**; Market Watch

Historical data shows that an ongoing pause is likely to be positive for equities, because the economy remains resilient for longer against expectations, while high rates keep rampant speculation in check. A slow grind up, which could last for many more months, is the most probable outcome as long as rates are held steady.

Interest Rate Cuts

Against common wisdom, I think that problems for stocks will only begin once the rate cut cycle starts. They will probably start to fall just before the initial cut, because there is going to be a serious, potentially systemic, problem coming up, which is necessary to trigger a rate cut cycle in the first place due to persistently high inflation. Equities are bound to react strongly to such an unexpected event, because it could mark the actual start of a highly-anticipated recession. The historical pattern here is quite clear: Stocks usually bottom several months after the beginning of a recession well into the rate cut cycle.

**Stocks fell 23,5% over 195 days on average *beginning* with the initial rate cut.**

Only after the final rate cut can we expect the FED Pivot to deliver its anticipated, positive result based on past occurrences: An 16% annual return for the S&P500 on average.

**The average drawdown from the start of a rate cut period was significant** (red bars).
**One year *after* the last rate cut returns are usually positive** (green bars); Investing.com

This article is based on the current market outlook in my weekly report. For more practical details on running a holistic investment & trading portfolio, and to support my research please consider subscribing. Thank you!

Good luck with your trading, and thank you for reading!

David

This is not financial advice.
These are my own views, as I may implement them in my own portfolio.
Please do your own due diligence!